New York Business Divorce

It Only Took 16 Years: New York Appellate Court Defines Standard for Judicial Dissolution of Limited Liability Companies

Peter A. Mahler — Mon, 08 Feb 2010 06:00:00 -0500

No more complaining about the absence of appellate guidance on the standard for judicial dissolution of limited liability companies under §702 of the LLC Law. Finally, almost 16 years after the cryptically-worded statute became law, the Appellate Division, Second Department, in Matter of 1545 Ocean Avenue, LLC, 2010 NY Slip Op 00688 (2d Dept Jan. 26, 2010), offers a carefully considered explanation of what §702 means -- and what it doesn't mean -- in a decision also notable for a two-judge dissent from the majority's disposition of the case without an evidentiary hearing.

As discussed below, the 1545 Ocean opinion's motif is fidelity to the LLC's operating agreement. This contract-centric approach sharply distinguishes LLC dissolution from partnership and close corporation dissolution cases in which implied fiduciary duties and untethered notions of fairness permeate the courts' analysis. It also brings New York LLC jurisprudence closer in line with Delaware's approach to LLC dissolution fueled by the admonition contained in §1101(b) of the Delaware LLC Act, to give "maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements."

It's no surprise that the signed opinion's author is Associate Justice Leonard B. Austin (pictured) who was appointed to the appellate bench in 2009 after serving ten years as trial judge in the Commercial Division of the Nassau County Supreme Court. Justice Austin's Commercial Division caseload, among other types of business disputes, included a steady influx of judicial dissolution proceedings involving closely held corporations and LLCs. That experience undoubtedly gave him a first-hand feel for the analytical and practical difficulties posed by these cases and an appreciation of the legal and business community's need for greater certainty in applying the broad and undefined terms of the dissolution statutes.

There's another reason I'm not surprised by Justice Austin's authorship. In June 2002, I wrote an article for the New York State Bar Association Journal on LLC dissolution (read it here) in which I observed that most of the few cases decided to that point freely borrowed from corporate dissolution norms applicable in cases involving oppressed minority shareholders and internal dissension. I did, however, cite a trial court decision in a case called Matter of Quinn, NYLJ Apr. 20, 2000, p. 32, col. 6 (Sup. Ct. Nassau County), as the sole example I'd found of a court, consistent with §702's language, focusing on whether the complained-of grounds for dissolution conformed to the members' operating agreement. The judge who decided Quinn? Justice Austin.

Now let's examine the 1545 Ocean decision.

The Facts

1545 Ocean Avenue, LLC ("1545 LLC") was formed in late 2006 as a manager-managed LLC with two 50% members, Crown Royal Ventures, LLC ("Crown Royal") and Ocean Suffolk Properties, LLC ("Ocean Suffolk"). Crown Royal and Ocean Suffolk entered into a written operating agreement for 1545 LLC in which Crown Royal designated its principal, John King, as one of the two managers and Ocean Suffolk designated its principal, Walter Van Houten, as the other manager.

Article 4.1 of the operating agreement contained a somewhat atypical management clause for 50-50 LLCs, authorizing "any one Manager [to] take any action permitted under the Agreement, unless the approval of more than one of the Managers is expressly required [by the Agreement]."

The two members each contributed 50% of the capital used to purchase commercial real estate located in Bohemia on Long Island. 1545 LLC's purpose was to purchase the property, rehabilitate an existing buidling (Building A) and build a second building on the property (Building B) for commercial rental.

King and Van Houten agreed to solicit third-party bids for the demolition and construction work. They also agreed that Van Houten, who owned his own construction company, Van Houten Construction ("VHC"), could submit bids subject to the managers' approval.

Ultimately VHC undertook the work on Building A, with Crown Royal later alleging that VHC did so without King's consent whereas Ocean Suffolk contended that the two managers agreed to hire VHC when there were no bona fide third-party bids. King also claimed that VHC began the work without necessary permits, did not have the proper equipment and consequently overbilled for the work. King alleged that he agreed to pay VHC's invoice on condition that it would cease further work without King's consent. VHC continued working on the site without King's consent.

Tensions between King and Van Houten further escalated following a dispute over hiring a contractor for environmental remediation work. According to King, Van Houten refused to meet on a regular basis, proclaimed himself to be a "cowboy" and stated that he would "just get it done". In April 2007, King announced that he wanted to withdraw his investment from 1545 LLC and proposed to notify all vendors that Van Houten was taking over. Van Houten viewed King as having resigned as manager. King's attorney sent Van Houten a "stop work" demand which was ignored. The two exchanged competing buy-out proposals of each other's interest, without resolution. Meanwhile, VHC continued to work unilaterally on the construction project which was within weeks of completion when Crown Royal sued for judicial dissolution and obtained an interim injunction preventing further work.

The Dissolution Petition

Crown Royal's petition alleged, as the sole ground for dissolution, deadlock between the managers arising from Van Houten's claimed violations of Article 4 of the operating agreement. The petition did not allege fraud or frustration of the purpose of 1545 LLC on the part of Ocean Suffolk, Van Houten or VHC.

Ocean Suffolk's answer to the petition opposed dissolution and denied any violation of the operating agreement. It alleged, without dispute, that the renovation of Building A was within 3-4 weeks of completion when the litigation commenced. It also alleged that, in anticipation of a buy-out of Crown Royal's interest, the parties had been operating as if Van Houten was sole manager. Ocean Suffolk thus contended that there could be no manager deadlock as a result of King's resignation as manager, even though King did not submit a written resignation as required by Article 4.8 of the operating agreement.

The Lower Court's Dissolution Order

In December 2007, the lower court issued a bare-bones order granting the dissolution petition (read it here). The order makes no factual findings, merely stating that judicial dissolution of an LLC "will be ordered only where the complaining member can show that the business sought to be dissolved is unable to function as intended, or else that it is failing financially," and that review of the papers submitted and the conferences conducted with the court "clearly demonstrates to this Court that 1545 is unable to function as intended."

Justice Austin's Majority Opinion

Ocean Suffolk appealed the order of dissolution to the Brooklyn-based Appellate Division, Second Department. Justice Austin's opinion for the 5-judge panel reverses the lower court's order, denies the petition and dismisses the proceeding. Presiding Justice Steven Fisher, joined by Associate Justice Cheryl Chambers, wrote a partial dissent in which he would have remitted the matter to the lower court for a fact-finding hearing to determining whether Crown Royal's petition met the newly-articulated standard for dissolution.

The LLC Dissolution Statute Distinguished from its Corporate and Partnership Counterparts

The analysis section of Justice Austin's opinion in 1545 Ocean, as its first order of business, tells the bench and bar what the standard for LLC dissolution is not, namely, it is not the standard developed for close corporations under the Business Corporation Law (BCL).

Upon the enactment of New York's LLC Law in 1994, the statute contained a single section denominated §702 governing judicial dissolution of the newly recognized entity. The section provides in its entirety as follows:

On application by or for a member, the supreme court in the judicial district in which the office of the limited liability company is located may decree dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement. A certified copy of the order of dissolution shall be filed by the applicant with the department of state within thirty days of its issuance. [Emphasis added.]

As I wrote in my 2002 article on LLC dissolution, the section's sparse language -- drawn from the limited partnership dissolution statute but rarely examined in the partnership case law -- created a vacuum into which many judges imported the relatively well-developed grounds for dissolution employed in cases involving close corporations under BCL §§1104 and 1104-a. It's easy to understand why courts did so given the many similarities between, on the one hand, corporate shareholder-officers and, on the other, LLC member-managers, at least when it comes to the day-to-day realities of their internal relations and the pressures that lead to internal dissension.

Justice Austin notes that §702 was left unchanged when the LLC Law was amended in 1999 to conform to changes in federal tax treatment of LLCs (citing my 2002 article in that regard), and from that concludes:

since the Legislature, in determining the criteria for dissolution of various business entities in New York, did not cross-reference such grounds from one type of entity to another, it would be inappropriate for this Court to import dissolution grounds from the Business Corporation Law or Partnership Law to the LLCL.

He then observes that, while there is no definition of "not reasonably practicable" in the context of LLC dissolution, "[s]uch standard . . . is not to be confused with the standard for the judicial dissolution of corporations or partnerships" (citations omitted). He notes that the BCL and Partnership Law by statutory definition apply only to business corporations and partnerships, respectively, and that "[l]imited liability companies thus fall within the ambit of neither the Business Corporation Law nor the Partnership Law." He also cites §102(m) of the LLC Law, which likewise excludes corporations and partnerships from its ambit, in concluding that "the existence and character of these various entities are statutorily dissimilar as are the laws relating to their dissolution."

The Court's Articulation of the Standard for Dissolution under §702

Having told us what the statute is not, Justice Austin next turns to the central question of §702's meaning. He notes that prior New York cases involving LLC dissolution "have avoided discussion of this standard altogether" leaving the issue unresolved. He also remarks upon the absence of case precedent construing the similarly-worded standard for dissolution under the limited partnership law.

The "not reasonably practicable" standard is linked textually in §702 to "conformity with the articles of organization or operating agreement." This linkage leads Justice Austin to state, quite significantly, that

LLCL 702 is clear that unlike the judicial dissolution standards in the Business Corporation Law and the Partnership Law, the court must first examine the limited liability company's operating agreement (see Matter of Spires v Lighthouse Solutions, LLC, 4 Misc 3d at 432) to determine, in light of the circumstances presented, whether it is or is not "reasonably practicable" for the limited liability company to continue to carry on its business in conformity with the operating agreement (id. at 433). Thus, the dissolution of a limited liability company under LLCL 702 is initially a contract-based analysis. [Emphasis added.]

The absence of New York precedent leads Justice Austin to look to LLC caselaw in other states with the same statutory standard for dissolution. Prominent among these cases is the Delaware Chancery Court's decision last year in Matter of Arrow Investment Advisors, LLC, 2009 WL 1101682 (Del Ch Apr. 23, 2009), where the court dismissed a minority member's application for dissolution of an investment advisory firm that had ceased its advisory business and essentially was reduced to a holding company for the firm's remaining cash and securities assets. The Chancery Court looked to the LLC agreement's broad purpose clause ("such . . . lawful business as the Management Committee chooses to pursue") in holding that, as quoted in 1545 Ocean,

"The court will not dissolve an LLC merely because the LLC has not experienced a smooth glide to profitability or because events have not turned out exactly as the LLC's owners originally envisioned; such events are, of course, common in the risk-laden process of birthing new entities in the hope that they will become mature, profitable ventures. In part because a hair-trigger dissolution standard would ignore this market reality and thwart the expectations of reasonable investors that entities will not be judicially terminated simply because of some market turbulence, dissolution is reserved for situations in which the LLC's management has become so dysfunctional or its business purpose so thwarted that it is no longer practicable to operate the business, such as in the case of a voting deadlock or where the defined purpose of the entity has become impossible to fulfill. . . . Dissolution of an entity chartered for a broad business purpose remains possible upon a strong showing that a confluence of situationally specific adverse financial, market, product, managerial, or corporate governance circumstances make it nihilistic for the entity to continue."

Other out-of-state cases cited by Justice Austin include Dunbar Group, LLC v Tignor, 267 Va 361, 593 SE2d 216 (2004), where the Supreme Court of Virginia, calling the statutory standard for dissolution a "strict one," reversed an order of dissolution based on deadlock between two 50-50 members of an LLC after the lower court had expelled one of the two members from participating in management; Kirksey v Grohmann, 2008 SD 76, 754 NW2d 825 (2008), where the South Dakota Supreme Court found the standard satisfied in a deadlock situation that left two of four sisters without any meaningful say in the LLC's business affairs contrary to the operating agreement; and a partnership case, Taki v Hami, 2001 WL 672399 (Mich. App. 2001), in which a Michigan appellate court granted dissolution where the two partners had not spoken in years and there were allegations of violence and expulsion.

Drawing on these cases, as well as the language of §702, Justice Austin announced the court's interpretation of the standard for LLC dissolution as follows:

After careful examination of the various factors considered in applying the "not reasonably practicable" standard, we hold that for dissolution of a limited liability company 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.

Notice how the two prongs of the standard -- I'll call them failed purpose and financial failure --are stated in the disjunctive but that each must be analyzed through the prism of the operating agreement or, if there is no operating agreement, in light of the LLC Law's default provisions. This is a significant shift from the less refined and arguably more liberal standard articulated in the one trial court decision that had gained a following, Schindler v. Niche Media Holdings, 1 Misc 3d 713 (Sup Ct NY County 2003), where the court wrote that dissolution of an LLC under §702 is available only if the company "is unable to function as intended, or else that is it failing financially." Henceforth, financial failure alone will not be enough to justify the drastic remedy of dissolution unless such failure is accompanied by, or results from, a frustration of the LLC's purpose that cannot be addressed or remediated by the operating agreement or articles of organization.

Notice also that, in contrast with the formulation recently used by the Delaware Chancery Court in the Lola Cars v. Krohn Racing case (read my post on Lola here), the 1545 Ocean court's formulation does not specify manager deadlock as a basis for dissolution. Indeed, Justice Austin elsewhere in his opinion states that deadlock, while expressly made a basis for dissolution of close corporations under BCL §1104, is not an "independent ground for dissolution" under §702. The court instead "must consider the managers' disagreement in light of the operating agreement and the continued ability of [the LLC] to function in that context." Presumably such consideration of deadlock fits within the unable-to-achieve-LLC's-purpose aspect of the failed-purpose prong, whereas the unwilling-to aspect seems better suited to dissolution cases brought by petitioners holding a minority membership interest.

The Court's Application of the Standard

Crown Royal argued for dissolution based on the parties' failure to hold regular meetings, failure to achieve quorums, and deadlock over the construction work and, in particular, Van Houten's continuation of the work using VHC despite King's objections. Writing for the 3-judge majority, Justice Austin held that Crown Royal's allegations "failed to meet the standard for dissolution enunciated here" and that, additionally, "there are numerous factors which support the conclusion that dissolution of 1545 LLC is inappropriate under the circumstances of this case."

Why did Crown Royal's petition fall short of the standard? First and foremost, Article 4.1 of the operating agreement (quoted above in the Facts section) permits one manager to act unilaterally unless the other manager's approval is expressly required. As Justice Austin noted, "[t]his provision does not require that the managers conduct the business of 1545 LLC by majority vote." Rather, he continued,

[i]t empowers each manager to act autonomously and to unilaterally bind the entity in furtherance of the business of the entity. The 1545 LLC operating agreement, however, is silent as to the issue of manager conflicts. Thus, the only basis for dissolution can be if 1545 LLC cannot effectively operate under the operating agreement to meet and achieve the purpose for which it was created. In this case, that is the development of the property which purpose, despite the disagreements between the managing members, was being met.

The operating agreement likewise did not require regular meetings or quorums. Instead, it merely provided for meetings to be held at such times as the managers "may from time to time determine." The record before the court, Justice Austin found, "demonstrates that the managers, King and Van Houten, communicated with each other on a regular basis without the formality of a noticed meeting which appears to conform with the spirit and letter of the operating agreement and the continued ability of 1545 LLC to function in that context."

What other circumstances rendered dissolution inappropriate? Justice Austin identifies three. First, the dispute between King and Van Houten "was not shown to be inimicable to achieving the purpose of 1545 LLC." King "never objected to the quality of Van Houten's construction work, but only to its expense". King "approved and praised" the work which was all but complete as to Building A.

Second, LLC Law §411 permits an LLC to avoid contracts entered into between it and an interested manager or another company in which a manager has an interest, unless the manager can prove the contract was fair and reasonable. Crown Royal could have, but did not, take action against the contract with VHC under §411. On the contrary, Justice Austin stressed, Crown Royal "ratified, albeit grudgingly at times, Van Houten's unilateral efforts." In any event, he continued, "a fair reading of LLCL 702 demonstrates that an application to dissolve 1545 LLC does not flow from a claim under LLCL 411."

Third, if aggrieved by Van Houten's actions as manager Crown Royal has an alternative remedy in the form of a common law derivative action under Tzolis v. Wolff, 10 NY3d 100 (2008). Such remedy, however, "cannot serve as the basis for dissolution unless the wrongful acts of a managing member which give rise to the derivative claim are contrary to the contemplated functioning and purpose of the limited liability company."

Justice Fisher's Partial Dissent

Justice Fisher's partial dissent begins with the observation that he has "no serious quarrel" with the standard for dissolution adopted by the majority. He briefly recounts the "growing disputes" between King and Van Houten over the latter's alleged mismanagement and billing improprieties in connection with the construction project. Justice Fisher states that Van Houten disputed many of King's allegations, and he notes that the lower court "made no findings of fact." Without such factual findings, he continues,

we cannot meaningfully decide whether the Supreme Court providently exercised its discretion in finding that the actions of the parties rendered it not reasonably practicable for 1545 LLC to carry on its business in conformity with its articles of organization or operating agreement. Accordingly, I would remit the matter to the Supreme Court, Suffolk County, for a fact-finding hearing and thereafter for a new determination on the petition (cf. Business Corporation Law § 1109; Sobol v Les Pieds Nickels, 262 AD2d 194, 196; Matter of Giordano v Stark, 229 AD2d 493, 494-495).

The requirement or not of a hearing in judicial dissolution proceedings can be as important to the outcome of the dispute as the formulation of the dissolution standard. I've seen dozens of appellate decisions reversing the grant or denial of a dissolution petition due to the lower court's failure to conduct an evidentiary hearing in the presence of conflicting affidavits concerning material issues of fact. I doubt that the majority's summary dismissal of Crown Royal's petition is intended to signal a change in direction on that score. Rather, the majority's disposition likely reflects its belief, not shared by the dissenters, that even crediting all of Crown Royal's factual allegations, along with its admissions as to the quality of VHC's work, it still does not meet the threshold for judicial dissolution of 1545 LLC.

Under §5601(a) of the Civil Practice Law and Rules, the dissent by two justices of the Appellate Division may permit Crown Royal to appeal as of right to New York's highest court, known as the Court of Appeals, at least with respect to the issue of its entitlement to a hearing. We'll just have to wait and see whether Crown Royal exercises its appellate rights or, perhaps, reaches some buy-out agreement or other accommodation with its business partner.

Addendum: Read here Professor Larry Ribstein's commentary on the Ocean 1545 case, from which I here quote his concluding paragraph emphasizing the importance of careful drafting of the LLC agreement:

In short, it seems that NY is joining Delaware in emphasizing the role of the operating agreement in judicial dissolution cases. As noted above, this could emerge as an important distinction between LLCs and close corporations, and therefore a factor in choice of form. It also places new emphasis on the need for care in drafting the operating agreement. However, New York has not yet explicitly embraced the operating agreement as determinative. We will have to await further developments to see if New York can shed its long legacy of close corporation law in LLC dissolution cases.

Interview with Delaware LLC Experts and Practice Manual Co-Authors John Cunningham and Vernon Proctor: Part II

Peter A. Mahler — Mon, 01 Feb 2010 06:00:00 -0500

Case Alert!!

Last week, the Brooklyn-based Appellate Division, Second Department, handed down the first substantive, appellate decision since the LLC Law's enactment 16 years ago defining the standard for judicial dissolution of limited liability companies under LLC Law Section 702. I'll be writing about it in next week's post. Here's the linked case citation for those who want to get a head start: Matter of 1545 Ocean Avenue, LLC, 2010 NY Slip Op 00688 (2d Dept Jan. 26, 2010)

Last week's post presented an interview with John Cunningham who, along with co-author Vernon Proctor, recently published the pictured practice manual called Drafting Delaware LLC Agreements. John, whose practice focuses on entity formation, addressed some important issues involving Delaware LLCs from the perspective of the drafter of the LLC agreement. In this Part II of the interview, we get Vern's perspective on Delaware LLCs as a seasoned litigator. As John explained last week, "Vern is the guy who makes sure that the book’s analysis of Delaware law is correct. Vern has an amazing knowledge of Delaware statutory and common law."

It's no surprise that John teamed up with Vern as his Delaware law expert. Vern is a founding partner of Proctor Heyman LLP in Wilmington, Delaware, where he has a diverse corporate litigation and counseling practice relating to Delaware business entities, primarily in the Delaware Court of Chancery. Vernon has lectured widely on subjects of Delaware corporate and limited partnership law, and he has served on the editorial boards of leading Delaware law publications. For ten years, he was a member of the Corporation Law Council of the Delaware State Bar Association, a group of attorneys that considers and recommends proposed changes to the Delaware General Corporation Law. He is currently a member of the Alternate Entities Committee of the Delaware State Bar Association, which serves the same function with respect to Delaware statutes governing general partnerships, limited partnerships, and limited liability companies.

In the following interview, Vern answers questions that I suspect are on the minds of many Delaware and non-Delaware lawyers, particularly litigators, whose practices deal with the evolving LLC form.

Mahler: There's a vast body of Delaware case law that lawyers should be aware of in forming Delaware LLCs. If you had to mention just the three or four most important cases, which would they be?

Proctor: As we say in the book, the most important (and, until recently, the only) Delaware Supreme Court opinion construing the Delaware Limited Liability Company Act is Elf Atochem N.A. v. Jaffari, 727 A.2d 286 (Del. 1999). There, the Court provided a comprehensive overview of the structure of the statute, highlighting freedom-of-contract principles and the manner of ascertaining mandatory, default and permissive provisions of the Act. Last month, the Supreme Court decided Olson v. Halvorsen, 2009 WL 4846616 (Del. Dec. 15, 2009), in which it affirmed a Chancery Court holding that the statute of frauds applies to Delaware LLC agreements, notwithstanding the Act’s express allowance of oral and implied LLC agreements. One of the most significant recent trial court decisions in the LLC area is Bay Center Apartments Owner, LLC v. Emery Bay PKI, LLC, 2009 WL 1124451 (Del. Ch. Apr. 20, 2009), where the Court of Chancery examined the efficacy of certain contractual attempts to restrict or eliminate common law fiduciary duties and applied the USACafes doctrine (directors of corporate general partners may owe fiduciary duties to the limited partners of the limited partnership, not just to the corporate general partner and its owners) in the LLC context. Finally, in R&R Capital, LLC v. Buck & Doe Run Valley farms, LLC, CA # 3803-CC (Del. Ch. Aug. 19, 2008), the Court of Chancery held as a matter of first impression that an LLC member could contractually waive its statutory right to seek judicial dissolution of a Delaware LLC, despite the absence from the statute of the phrase “unless otherwise provided in the LLC agreement.” As always in Delaware, check the unreported decisions!

Mahler: On the basis of your Delaware LLC litigation practice, are there any important tips you have for lawyers drafting Delaware LLC agreements?

Proctor: As with any contract drafting, be as precise as you possibly can. This “goes double” for any effort to modify or eliminate common law fiduciary duties pursuant to Section 18-1101 of the Act. Drafters sometimes purport to eliminate all common law fiduciary duties from the deal, but they may inadvertently create their own contractual fiduciary standards. Litigation concerning LLC agreements often turns on whether the subject provisions are ambiguous or unambiguous. If there is an unambiguous “plain meaning,” litigations can often be decided quickly and inexpensively on the pleadings or on summary judgment, rather than requiring expensive discovery and a trial on a “search for the parties’ intent.”

Mahler: Do you think there are any important issues of malpractice or unauthorized practice that non-Delaware lawyers should consider in deciding whether to form Delaware LLCs? In forming these LLCs, should these lawyers always associate themselves with Delaware lawyers?

Proctor: The Delaware LLC Act is a complex statute. If I were a New York lawyer charged with drafting a Delaware LLC agreement for a New York client, particularly for the first time, I would certainly consult with an experienced Delaware LLC practitioner at an early stage of the process. Even transactional lawyers should be aware of such basic concepts as what constitutes the unauthorized practice of law in their home jurisdictions as well as in Delaware: Rule 5.5 of the Delaware Lawyers’ Rules of Professional Conduct provides the principal guidance on that score. Try to ascertain what constitutes practicing law “in another jurisdiction…on a temporary basis.” Never hold yourself out as a Delaware attorney if you’re not licensed to practice there. Make all appropriate disclosures of your bar admissions and experience to your client before accepting the assignment. Check the language of your malpractice policy as well. It’s all common sense.

Mahler: Section 1101(b) of the Delaware LLC Act permits the parties to LLC agreements to eliminate fiduciary duties in these agreements, but not the implied contractual covenant of good faith and fair dealing. Does the covenant provide Delaware LLC members with most or all of the protection they'll need against manager fiduciary breaches?

Proctor: As a litigator, I’m always reluctant to rely heavily on the implied contractual covenant of good faith and fair dealing, except in those rare cases where the LLC agreement unambiguously eliminates both fiduciary duties and liability for breach of contract. For one thing, Delaware courts have been parsimonious in applying the implied covenant. If a provision of the LLC agreement expressly covers the issue as to which the implied covenant claim is made, the claim fails as a matter of law. The court will imply a contractual term only on rare occasions where the agreement is silent.

Mahler: Is there also a difference with respect to damages?

Proctor: In breach of fiduciary duty cases, the Court of Chancery has considerable flexibility, as a court of equity, in fashioning a damage award that will make the LLC or an aggrieved member whole. Where there is an actionable breach of contract, Delaware courts will apply a traditional expectancy or reliance damages measure in most cases. There doesn’t seem to be a fixed standard in implied covenant cases, however. In a few such decisions, the court awarded consequential damages, such as legal fees. To sum up, the implied covenant – standing on its own, at least – is a rather poor substitute for fiduciary protections, whether common law or contractual.

Mahler: By its terms, Section 18-108 of the Delaware LLC Act permits LLCs to indemnify managers and other persons "from and against any and all claims whatsoever." Does this mean that LLCs can indemnify managers even for breaches of the Implied Covenant?

Proctor: I read the language of Section 18-108 very straightforwardly. The power to indemnify against “any and all claims whatsoever” means what it says and covers implied covenant claims as well as contractual and fiduciary claims. This may appear to be inappropriate in view of Section 18-1101(b)’s prohibition of eliminating the implied covenant from LLC agreements and Section 18-1101(e)’s preservation of all liabilities for “bad faith violation[s]” of the implied covenant. Given the sweeping language of Section 18-108, however, I would be very surprised if a “public policy” exception was read into the statute by a court to effect a carveout for implied covenant claims. The Court of Chancery has already stated that you can’t construe Section 18-108 in light of the constraints on indemnification contained in the analogous corporate statute, Section 145 of the Delaware General Corporation Law. See, e.g., Bernstein v. TractManager, Inc., 953 A.2d 1003, 1009-10 & n.23 (Del. Ch. 2007).

Mahler: What do you see as the two or three most important unanswered legal issues in Delaware LLC formations on which you'd like to see rulings from the Delaware Supreme Court?

Proctor: Given recent articles by jurists and legal scholars that question the efficacy of common law fiduciary duties in the LLC context, I’d like to see the Delaware Supreme Court rule definitively on the question of whether such duties even exist. Lower court decisions assume a positive answer to the question in determining whether such duties have been restricted or eliminated pursuant to Section 18-1101(b), but there hasn’t been much analysis of the underlying threshold question. Given my understanding of older partnership cases and the evolution of the LP and LLC statutes over time, I suspect that an affirmative answer would be given to that question. I’d also like to see the Supreme Court eventually resolve the issue discussed above concerning indemnity for implied covenant breaches. Otherwise, most LLC cases seem to be resolved on traditional principles of contract interpretation. That’s probably the way it should be.

Mahler: Vern, many thanks for your thoughtful analysis, and congratulations to you and John on publishing a very fine practice manual.

Interview with Delaware LLC Experts and Practice Manual Co-Authors John Cunningham and Vernon Proctor: Part I

Peter A. Mahler — Mon, 25 Jan 2010 06:00:00 -0500

In almost all states, the limited liability company in recent years has become the business organization form of choice for closely held entities. By far the most popular LLC Act for use in forming sophisticated LLCs is the Delaware Act. There are presently something like 7 million U.S. LLCs of which approximately 600,000 are Delaware LLCs.

As a New York practitioner who handles all types of messy disputes between business co-owners, I know first hand the outsized claim of Delaware law on jurisdictional choice of entity as well as the powerful influence of Delaware decisional law even in disputes involving non-Delaware entities. I also know -- because it's written right into the Delaware LLC Act -- that freedom of contract is the cornerstone of Delaware LLC jurisprudence, and therefore nothing contributes more to the long-term health and welfare of a Delaware LLC -- or any LLC, for that matter -- than having a carefully planned, comprehensive, forward-looking, well-drafted operating agreement.

In 2009, Wolters Kluwer Law & Business published what quickly has become the preeminent formbook and practice manual on forming Delaware LLCs entitled Drafting Delaware LLC Agreements. The co-authors are John M. Cunningham and Vernon R. Proctor. I am very pleased to present this first of a two-part interview of the authors of this extremely well-written and user-friendly manual, which also includes a CD containing over two dozen sample Delaware operating agreements.

In this first part of the interview I talk with John Cunningham (pictured left), a member of the New Hampshire and Massachusetts bars whose practice focuses on forming LLCs for business start-ups and on restructuring existing businesses. Among his many achievements John was a principal drafter of the New Hampshire LLC Act. He is not only the co-author of Drafting Delaware LLC Agreements but also is the sole author of Drafting Limited Liability Company Operating Agreements, the leading U.S. general (i.e., non-state specific) LLC formbook and practice manual. I hope you find the interview, which begins after the jump, as interesting and useful as I did.

Mahler: John, who are the principal readers for whom you and Vern wrote your book and what is the book’s main purpose?

Cunningham: We wrote the book for Delaware and non-Delaware lawyers who represent clients in Delaware LLC formations. The book’s purpose is to provide these lawyers with all of the basic knowledge and practice tools—including, above all, model LLC agreements—they will need in order to handle these formations at a high level of competence and efficiency.

Mahler: How have you and Vern allocated the work of writing and updating your book?

Cunningham: I’m the principal idea man and the scrivener. Vern is the guy who makes sure that the book’s analysis of Delaware law is correct. Vern has an amazing knowledge of Delaware statutory and common law.

Mahler: Pardon my nosiness, but do you and Vern ever disagree about significant issues in the book?

Cunningham: Frequently; and sometimes on very basic issues. For example, I think that under the first sentence of DLLC Act § 18-402, it’s clear that the members of Delaware LLCs have broad voting powers on LLC fiduciary matters such as indemnifications. Vern disagrees. But since other leading Delaware lawyers support Vern’s view, I’ve yielded on this issue. But the key point here for lawyers handling Delaware formations is this: When in doubt, resolve arguable ambiguities in the DLLC Act by careful drafting in your LLC agreement. Under the freedom-of-contract provision of DLLC Act § 18-1101(b), you can be very confident that your drafting will be legally valid. That’s the approach Vern and I take in our book when we disagree on key issues of Delaware statutory or common law.

Mahler: In your view, what constitutes a good Delaware LLC form?

Cunningham: First of all, lawyers forming Delaware LLCs shouldn’t think in terms of “a” form but rather in terms of sets of forms. On the basis of their ownership structure, their management structure and their federal tax structure, there are 10 quite distinct types of Delaware LLCs. To be fully equipped to form these LLCs, you need 29 main forms. For example, the provisions in LLC agreements for Delaware single-member LLCs owned by individuals should be significantly different from those owned by entities; for Delaware multi-member LLCs, you need separate forms for those with general partnership management structures, limited partnership management structures and corporate management structures; and for a Delaware series LLC, you need a highly specialized form.

Mahler: And once you decide upon the basic template that's right for the structure of the particular LLC, what optimal form features should one look for?

Cunningham: Above all, the form should identify in its captions all of the business organization law issues, tax issues and other issues likely to be relevant to the type of LLC for which it is drafted. In the case of manager-managed multi-member LLCs taxable as partnerships, this means more than 200 principal and subsidiary issues, including, for example, member dissociation issues, manager fiduciary issues, buy-sell issues, dispute resolution issues, and a slew of federal tax issues. Finally, Vern and I share the common-sense view that all good Delaware forms should be written in plain English that, for the most part, even non-specialists can understand on a careful first reading.

Mahler: What principal types of knowledge do you think lawyers need in order to form Delaware LLCs competently?

Cunningham: Above all, they need a detailed knowledge of the provisions of the DLLC Act relevant to Delaware LLC formations. By our count, this includes about 168 main provisions. And they need to be able to categorize each of these provisions accurately as mandatory, definitional, default, non-self-enabling permissive and self-enabling permissive, since these characterizations can critically affect how you negotiate specific issues in an LLC deal. But they also need a lot of “meta-knowledge”—that is, knowledge that is based on the relevant statutory and case law but that is essentially know-how on how to perform key Delaware formation tasks. These tasks include choosing between Delaware LLCs and Delaware corporations for clients; and choosing whether to form clients’ LLCs under the Delaware LLC act or some other act.

Mahler: What main factors do you think lawyers should consider in choosing between the DLLC Act and non-Delaware acts?

Cunningham: The issue is complex, but here are some key considerations:

If you’re representing the promoter of an investment LLC who will appoint the LLC’s manager and who wants him or her to have substantial protection from member fiduciary claims, you should generally form the LLC under the Delaware LLC Act. This is because the Delaware Act provides greater scope and flexibility in drafting these protections in LLC agreements than any other act; and because DLLC Act § 18-1101(b) and the Elf Atochem case go very far in ensuring the validity of these protections.
If your clients’ LLC’s businesses will involve substantial financial stakes and a significant risk of internal disputes, you need to form the LLC under the DLLC Act in order to ensure access to the Delaware Court of Chancery—in my view, the best business court in the U.S. I recently formed an investment LLC with 100 members and an initial capitalization of $600 million. I couldn’t imagine forming that LLC under any non-Delaware LLC act even though none of its members resides in Delaware. The key factor was the excellence and efficiency of the Court of Chancery.
Not that there aren’t reasons for not forming LLCs under the Delaware Act. For example, it’s often said that “everybody’s second choice is Delaware”—i.e., that when an LLC has two or more members and none of them wants to use the others’ LLC act, you should use the Delaware Act. This saying sometimes makes sense. However, the DLLC Act is tricky, and you shouldn't form LLCs under it unless you have the necessary expertise. And do you really want to have to try LLC internal disputes in Wilmington, Delaware?

Mahler: John, thanks for taking the time to share your expertise with my readers. I look forward to learning even more from your co-author, Vern Proctor, in next week's Part II interview.

Do Advancement and Indemnification Rights Include Defense Costs of Litigation Misconduct After Officer Leaves Company?

Peter A. Mahler — Mon, 18 Jan 2010 06:00:00 -0500

If there's a more litigious partnership falling-out than that of the closely-held mortgage company, Private Capital Group (PCG), I don't know about it. The case, entitled Ficus Investments, Inc. v. Private Capital Management, LLC, has racked up 87 motions since it was filed in Manhattan Supreme Court in March 2007, including several contempt applications. The court's docket lists over 2,300 separate documents filed, and the case isn't even close to being tried. There have been three interlocutory appeals decided thus far, with several others awaiting decision. Did I mention the parties have filed at least five other, related cases?

PCG was a New York-based Florida limited liability company formed to buy, manage and sell non-performing mortgages. Ficus Investments, Inc. (Ficus), the 80% member and sole manager of PCG, put up $300 million debt financing. Private Capital Management (PCM), the 20% member, operated PCG's mortgage business by PCM's two beneficial owners, Thomas Donovan and Lawrence Cline. The conflagration started a little over a year after operations began, in March 2007, when Ficus ousted Donovan and Cline and brought suit accusing them of misappropriating over $20 million.

The complex, high stakes litigation not surprisingly has generated millions in legal bills, which in turn has spawned a litigation within the litigation over the issue of the defendants' entitlement to advancement and indemnification of legal expenses under the provisions of PCG's operating agreement.

A year ago I wrote about a January 2009 appellate decision in Ficus in which the court held that the primary defendant, Thomas Donovan, as a former officer of PCG was entitled to seek advancement of his legal defense costs under the operating agreement. The primary issue there was whether the trial court's issuance of preliminary injunctions against Donovan defeated his advancement rights. Manhattan Commercial Division Justice Bernard Fried ruled (read here), and the Appellate Division affirmed (read here), that the ultimate determination of Donovan's indemnification rights had no impact on his interim advancement rights under the operating agreement's terms. The rulings resulted in reimbursement to Donovan of approximately $1.5 million in legal fees incurred through the end of 2007, which was upheld by yet another appellate court ruling in June 2009 (read here).

As it turned out, 2007 was just a warm-up for the next year, in which Donovan incurred another $3.8 million in legal defense costs for which he also sought advancement. Ficus opposed the bulk of the request, arguing that Donovan was not entitled to advancement for fees incurred opposing Ficus's applications for discovery and contempt sanctions concerning Donovan's alleged misconduct after he was terminated as an officer, during the course of litigation. Donovan's alleged misconduct included the "hacking" of former co-defendant Cline's e-mail account -- early in the case Cline and Ficus entered into settlement and cooperation agreements -- and failing to turn over company books and records in violation of court order.

The arguments raised in this second go-round, and the court's recent decision in favor of Ficus, raise novel legal issues with important ramifications for advancement and indemnification litigation in this and other cases.

Here's a summary of the proceedings leading to the latest decision:

The litigation began in March 2007, shortly after which Justice Fried issued orders requiring Donovan to turn over Ficus books and records.
In September 2007, Ficus filed a motion by Order to Show Cause (read here) seeking to hold Donovan in civil contempt of court for failing to return company funds along with certain books and records.
In a November 2007 order (read here), based on the parties' conflicting allegations, Justice Fried referred the books and records dispute to a Special Referee to hear and report.
In May 2008, Ficus filed another motion by Order to Show Cause (read here) asking the court to impose various sanctions against Donovan allegedly for gaining unauthorized access to (i.e., hacking) Cline's e-mail account beginning in November 2007, and thereby obtaining confidential attorney-client communications.
In a July 2008 order (read here), Justice Fried found disputed issues of fact requiring a hearing, and again referred the matter to the same Special Referee to hear and report.

The Special Referee held lengthy evidentiary hearings and issued two reports, in August 2009 (read here) and November 2009 (read here) in which she concluded: (1) that Donovan deliberately violated Justice Fried's orders requiring the turnover of Ficus books and records and should be held in contempt with appropriate sanctions including costs engendered by his actions; and (2) that Donovan without authorization accessed Cline's confidential e-mail communications and should be sanctioned by the dismissal of his claims against Cline and others, and reimbursement of Cline's and Ficus's counsel fees. Both reports currently are the subject of dueling motions to confirm and to reject the Special Referee's findings and recommendations.

The Special Referee also conducted a separate evidentiary hearing as to Donovan's request for advancements totaling $3.8 million for legal expenses incurred in 2008. Her July 2009 report (read here) found that Donovan's acts of hacking e-mail and his removal and non-disclosure of books and records occurred well after he left office at Ficus and were never intended for the benefit of anyone but himself. The Special Referee recommended that Donovan was only entitled to advancement of counsel fees in the approximate amount of $1.8 million, or about $2 million less than he sought, reflecting her exclusion of expenses incurred primarily for the books and records and e-mail hacking proceedings.

Ficus and Donovan filed motions to confirm and to reject, respectively, the Special Referee's July 2009 report insofar as it excluded fees for the books and records and e-mail hacking proceedings. The lengthy briefs submitted by both sides raise a host of issues and arguments, factual and legal, beyond the space limitations of this post. In a nutshell, Ficus contended that the operating agreement's provision for advancement and indemnification of expenses of an officer "who is a Party to a Proceeding because he or she is a[n] . . . Officer" does not encompass expenses unrelated to the person's conduct as an officer. Donovan countered that the agreement's quoted language does not permit the extraneous consideration whether the particular subject matter of a motion or hearing within the "Proceeding" concerns the defendant's conduct as an officer. (For anyone interested in reading the parties' briefs, here they are: Donovan Brief; Ficus Brief; Donovan Reply Brief; Ficus Reply Brief).

In his Decision and Order dated December 22, 2009, Justice Fried sided with Ficus and upheld the Special Referee's determination to exclude the $2 million relating to the books and records and e-mail hacking proceedings. Here's the key passage from the court's decision:

There is no dispute that if Donovan were made a party to this action on the basis of conduct other than that which he engaged in as an Officer of PCG, he would not be entitled to advancement or indemnification under the Operating Agreement. Likewise, Donovan cannot expect to be advanced funds to cover the expenses incurred in connection with defending against allegations of misconduct that commenced after he left PCG. That the misconduct complained of was undertaken in connection with the suit against Donovan the Officer is of no moment; it was Donovan the individual who took the actions, for the benefit of and on behalf of, Donovan the individual. There is no requirement within the Operating Agreement that PCG advance the litigation expenses of Donovan the individual. The Special Referee's conclusion that the mere fact that certain expenses arose out of the action in which Donovan the Officer was sued "is not necessarily sufficient to mandate that the fees" are advanceable, and her conclusion that fees for hearings on activities undertaken - admittedly - on Donovan's own behalf and not on behalf of the Company are outside the scope of advanceable fees, are thus not erroneous.

The arguments on both sides raise important considerations of contract construction, the policies underlying advancement and indemnification of company officers, and conservation of judicial resources. The threshold analytical hurdle stems from the fact that all conduct undertaken by a former officer in the course of a company-brought litigation for abuse of office, by definition, is conduct not undertaken "as an officer" of the company. What principal distinguishes conduct within or outside the duty to advance and indemnify? Donovan's bright-line, contract-based argument offers the advantage of certainty -- not a small consideration given the purpose of advancement and indemnification clauses to encourage service as a company officer or director -- and reduced judicial intervention. Yet it also could encourage a former officer to engage in abusive extra-judicial tactics under the guise of defense measures, or force the company to commence a separate lawsuit for post-termination litigation misconduct so as not to implicate the advancement and indemnification provisions.

Justice Fried undoubtedly is correct in suggesting that, had Ficus sued Donovan in a separate lawsuit for damages or other relief not directly impairing Donovan's defense of Ficus's claims in the main action, Donovan would not have a basis to seek advancement and indemnification. The relief requested in the Orders to Show Cause (linked above) submitted by Ficus in support of its motions relating to the books and records and e-mail hacking proceedings appears to include preclusion orders directed at Donovan's use of evidence in his defense of Ficus's claims against him for his conduct as a former officer, as well as seeking other preclusion orders directed against Donovan's prosecution of his own claims against Ficus. On the other hand, the Special Referee's recommended sanctions, assuming they're adopted by the court, don't appear to include any preclusion of Donovan vis-a-vis his defense of the main action. Should any of these factors make a difference?

More questions: Does a litigation-misconduct exception to advancement and indemnification pose a slippery slope, implicating many, easily imagined scenarios in which the defendant's actions relating to the litigation cannot readily be pigeon-holed as related solely to defense of the company claims versus in pursuit of personal objectives? Will the court be required to make factual inquiry and findings in each instance whether the conduct somehow relates to the defense of the company's claims versus promotion of the former officer's extra-litigation objectives? Should company counsel revise the advancement and indemnification clauses used in bylaws and agreements to carve out conduct such as that at issue in Ficus, and if they do so, will it have a chilling effect on willingness to serve as an officer or director?

It looks like these questions are destined to be answered by a higher authority. Donovan's counsel recently filed a notice of appeal from Justice Fried's ruling and, given the amount at stake, it's probably a safe bet that the appeal will be perfected and that, some time later this year, the appellate court will have its say. Stay tuned.

Winding Up an Acrimonious Partnership Following Death of a Partner

Peter A. Mahler — Mon, 11 Jan 2010 06:00:00 -0500

According to a summary on the website of the Uniform Law Commissioners, thirty-four states have adopted the Revised Uniform Partnership Act of 1994 (RUPA) which, among other significant changes to the original Uniform Partnership Act of 1914 (UPA), no longer provides for automatic dissolution of a general partnership upon the ordinary dissociation of a partner, including upon the death of a partner. Under the default rules of RUPA §§601 and 801, the partnership continues after the death of a partner subject to the partnership's obligation under §701 to purchase the deceased partner's interest for a buyout price equal to the greater of liquidation or going-concern value. (Read here a summary of RUPA's major revisions. Read here the text of RUPA.)

New York is in the minority of states that has not adopted RUPA. Thus under §62(4) of New York's UPA-based Partnership Law enacted in 1919, absent contrary agreement the death of a partner automatically triggers dissolution of an at-will general partnership. While Partnership Law §73 permits continuation of the partnership accompanied by a buyout of a deceased member's interest under certain, narrowly-defined circumstances (e.g., see my previous piece on the Vick v. Albert case), otherwise the partnership must be dissolved and its business wound up.

Such was the case in Matter of Franzese (Franzese Realty Associates), 2009 NY Slip Op 33139(U) (Sup Ct Nassau County Dec. 16, 2009), in which Nassau County Commercial Division Justice Timothy S. Driscoll was tasked with cleaning up a messy dispute between the surviving siblings of a family-owned real estate partnership. Franzese does not involve any novel legal issues, but it nonetheless merits attention as an example of how courts deal with some of the typical problems that arise during the winding up of the partnership, and particularly the question of receivership.

Franzese Realty Associates is a family-owned business that owns and operates real estate on Long Island. It was founded by Charles Franzese who died in 1987, after which the three partners consisted of his children Patrick, Donna and Rosemarie. Apparently there never was a written partnership agreement. Since the father's death, virtually all of the partnership's actions were determined by 2/3 vote with Donna as the lone dissenter. Among such actions was the decision by Patrick and Rosemarie to manage the partnership's business through a separate management company formed by Rosemarie who was a licensed real estate broker. After 1990, Rosemarie and her daughter Lucille as an employee of the management company performed all duties relating to the marketing and financial obligations of the partnership.

The acrimony between Donna and her siblings was acute. Between 1990 and 2007, Donna commenced five litigations against her family members relating to the partnership, including challenges to her father's and mother's wills; an action alleging that Patrick and others defrauded her of her interest in the partnership properties and seeking to remove Rosemarie as managing agent; another action against Rosemarie demanding an accounting; and an action for partition of the partnership properties. All of the proceedings terminated with dismissal or voluntary discontinuance.

Rosemarie died in March 2009. In September 2009, Patrick brought a court petition seeking a declaration that the partnership was dissolved pursuant to Partnership Law §62(4) as of the date of Rosemarie's death, directing that the partnership's affairs be wound up, and that a partnership accounting be prepared. Patrick's petition also asked that the court appoint him receiver of the partnership during the winding up (see Partnership Law §§68 and 74) with authority to sell the assets at public auction and to retain Rosemarie's company and her surviving daughter, Lucille, to serve without compensation as managing agent during the winding up, and enjoining Donna from interfering with the winding up.

Donna consented to the petition's request to wind up the partnership's affairs and to sell its assets at auction, however, she opposed appointment of Patrick as sole receiver and the appointment of Rosemarie's company as managing agent, and she also opposed any restraint on her own participation in the winding up. Donna contended that Lucille did not have experience as managing agent and that she would have "no problem" working with Patrick in the winding up notwithstanding the past acrimony and litigation.

Justice Driscoll's decision and order grants the unopposed request for a declaration of dissolution as of the date of Rosemarie's death under §62(4). As to the contested issue of control during the winding up, Justice Driscoll notes that under §68 the surviving partners have the presumptive right to wind up the partnership affairs. He also observes that the appointment of a receiver is an "extreme remedy" that should be "used sparingly in partnership dissolution actions" and is justifiable only when the party requesting it "has made a clear evidentiary showing of the necessity for the conservation of the property at issue and the need to protect the moving party's interests." He then concludes that Patrick's showing falls short of the standard, stating as follows:

While it is clear that the relationship between [Patrick] and [Donna] is strained, and that [Donna] has instituted extensive litigation related to the Partnership in which she has not been successful, the Court cannot conclude that she has engaged in fraud or waste that would support the appointment of a receiver. For the same reasons, the Court denies [Patrick's] applications for injunctive relief and an accounting.

It's hard to argue with this analysis. After all, Donna was the outside, non-managing partner over the prior twenty years. Rather, the situation called for the court to predict, based on past, unsuccessful legal challenges by Donna, that Donna's co-equal stewardship of the winding up as presumptively allowed by §68 would result in a dissipation of partnership assets. While Justice Driscoll was not prepared to engage in such speculation, he did see fit to give Donna a gentle reminder of her promise to work cooperatively alongside her brother, writing:

The Court is hopeful that [Donna] is being candid when she affirms that she is willing to work with [Patrick] in the winding up, and that the winding up can be effected without future litigation.

Justice Driscoll's order accordingly denies appointment of a receiver, authorizes the partnership business to be continued by Patrick and Donna during the action's pendency upon each of them filing a $50,000 surety's bond, and directs them to conduct the winding up in the manner prescribed by Partnership Law §71 governing distributions.

In recent decades this kind of general partnership case involving real property assets has become exceedingly rare due to the tax and liability concerns favoring use of S corporations and limited liability companies. Outside the family context, it's just as rare to find a general partner who, unlike Donna, is not actively involved in the business. When the occasion does arise involving serious acrimony between managing partners, the courts are more likely to appoint a neutral receiver to oversee the winding up.

Court Invalidates Control-Shifting Stock Transfer Made in Violation of Corporation's Right of First Refusal

Peter A. Mahler — Mon, 04 Jan 2010 06:00:00 -0500

The right of first refusal (RFR) is a type of stock transfer restriction found in shareholder agreements of closely held corporations. Under the most common form of RFR, the shareholder seeking to transfer his or her shares to another person is required to submit sequentially to the corporation and, if the corporation declines, to the other shareholders the opportunity to purchase the shares on the same terms as are being offered by the proposed purchaser. The courts routinely enforce RFRs in recognition of the special partnership-like character of close corporations.

A recent decision by the Appellate Division, First Department, in Giaimo v. EGA Associates Inc., 2009 NY Slip Op 09277 (1st Dept Dec. 15, 2009), illustrates the mischief that can occur when the RFR is not properly spelled out in a shareholders' agreement but, instead, is set forth in abbreviated and incomplete form on the back of the share certificates. Giaimo also illustrates the paramount importance New York courts place on the fiduciary duties owed by majority shareholders and directors of close corporations to minority shareholders, arguably to the point of preempting the statutory scheme governing director's self-interested transactions.

EGA Associates Inc. (EGA) is a closely held New York corporation formed in 1961 to own and operate real estate. According to the complaint filed by Robert Giaimo (read here), the stock of EGA was held one-third each by Robert and his siblings, Edward and Janet. Edward died after a long illness in March 2007. Edward's will bequeathed his EGA shares in equal parts to Robert and Janet, which would have left them as equal 50% shareholders. Two weeks before his death, however, Edward sold one of his shares to Janet for $80,000, thereby giving her majority ownership upon Edward's death. Some months later, Janet gave notice of meetings of the shareholders and directors at which she obtained voting control of the board by electing herself and her lawyer as two of the three directors.

Robert's lawsuit sought declaratory and injunctive relief setting aside the sale of stock by Edward to Janet on the ground it violated the crude RFR printed on the back of the stock certificates issued to each of the three siblings, providing as follows:

Shares are not transferable without granting the corporation thirty (30) days written notice of sale of terms, involved parties and a first option to purchase said shares before transfer to other existing shareholders or to third parties, except in the case of transfers to immediate family (spouse and children only). Such restrictions shall not apply [sic]. Corporate first option preserved for all subsequent transfers.

Janet defended the stock sale by alleging that, before he died, Edward told her that, in his capacity as EGA's president, he had waived EGA's right of first refusal prior to the sale, although apparently the waiver was never separately documented. Janet also contended that Edward believed that Robert would sell his shares in EGA, and that he decided to sell one of his shares to Janet to ensure that EGA remained within the family and to prevent shareholder gridlock.

Robert moved for summary judgment canceling the sale and voiding the actions taken at the subsequent shareholder and director meetings. He argued that Janet's testimony relating Edward's statement concerning the company's waiver of the RFR was barred by the Dead Person's Statute, codified in Section 4519 of the Civil Practice Law and Rules. Robert alternatively argued that the sale was invalid under Section 713(a) of the Business Corporation Law which authorizes interested-director transactions upon appropriate disclosure and approval vis-a-vis disinterested directors and/or shareholders.

The trial court, in a decision by New York County Supreme Court Justice Marcy S. Friedman reported at 2008 NY Slip Op 32944(U) (Sup Ct NY County Oct. 28, 2008), denied Robert's motion. First, she ruled that the Dead Person's Statute did not bar Janet's testimony concerning her discussions with Edward at the pre-trial phase where there is other admissible, corroborating evidence including a bill of sale for the stock and a new stock certificate, both authenticated by Edward's personal assistant. Second, Justice Friedman ruled that Robert had not eliminated triable issues as to whether, as EGA's president, Edward had authority to waive the RFR without board approval. Third, she ruled that even if BCL Section 713 applied, Robert failed to eliminate triable issues as to whether the stock sale to Janet was fair and reasonable to EGA under subsection (b) of the statute, which would allow an interested-director transaction that otherwise fails to comply with the disclosure and approval requirements. As to the last point, the court cited Janet's contention that Edward's alleged desire to prevent shareholder gridlock constituted a "bona fide purpose" for the stock sale. Justice Friedman also cited testimony by EGA's accountant who suggested that the $80,000 paid by Janet over-valued the share of stock, at least compared to its book value.

Robert appealed the trial court's decision to the Appellate Division, First Department, which unanimously reversed the decision and entered summary judgment in Robert's favor voiding the stock sale and the subsequent actions taken at shareholder and directors meetings. The court's short decision expressly rejects Janet's argument based on Edward's alleged waiver of the RFR, holding that "[a]s the president of a closely held corporation, Edward lacked the power to act unilaterally against Robert's interest" and citing several precedents in which courts recognize the fiduciary duties owed by majority shareholders to the minority in closed corporations. The decision also rejects Janet's argument that the transfer restrictions on the stock certificates were invalid in the absence of other "corporate documents evidencing their approval," adding that "the three shareholders accepted these restrictions without objection and relied on them until after this litigation was commenced."

Notably absent from the appellate decision is any mention of Janet's argument, accepted by the trial court, that the company's alleged waiver of the RFR in an interested-director transaction, notwithstanding non-compliance with the disclosure and approval requirements of BCL 713(a), might be sustainable under BCL 713(b) as "fair and reasonable as to the corporation." I can think of at least two possible reasons for the omission. First, the stock sale apparently was never formally submitted to the board or the shareholders for a vote, so it's not clear by its terms that BCL 713(b) applies. Second, the waiver dispute in this case is linked inextricably to the predominant question of shareholder control of a closely held corporation, i.e., it is not primarily a question of what's fair and reasonable to the corporation which generally has no independent, cognizable interest in deciding who holds the reins of management. This second reason opens the door wide to the appellate court's elevation of fiduciary duty owed to minority shareholders as the deciding principle.

As mentioned above, a fully developed RFR provision in a shareholders' agreement likely would have avoided this dispute. Among other things, it would have required that the share be offered to the other shareholders in the event the company opted not to acquire the share. Such a provision would have enabled Robert to maintain his 50% interest.

One final footnote. In July 2007, Robert filed a separate petition to dissolve EGA pursuant to the deadlock dissolution statute BCL 1104, as well as under the oppressed minority shareholder statute BCL 1104-a (read petition here). Janet thereafter elected to purchase the petitioner's shares in lieu of dissolution. It appears that a valuation hearing was conducted in 2009, before the appellate ruling discussed above, but that there's been no valuation decision much less a consummation of the buyout. It will be interesting to see whether and how the appellate court's invalidation of the stock sale to Janet will affect the pending dissolution/buyout proceeding.

Top 10 Business Divorce Cases of 2009

Peter A. Mahler — Mon, 28 Dec 2009 06:00:00 -0500

I'm pleased to present the second annual list of my selections for the year completed's top-10 business divorce cases -- a dubious honor at best for the litigants involved, but no less titillating for the rest of us voyeurs (although one of the cases, Ravitz, I handled). Half of this year's crop concerns issues arising out of LLC disputes, which is consistent with the growing importance of the LLC as the business form of choice for closely held firms. All of these cases were featured in this blog previously; click on the case name to read the full treatment. And the winners are:

Gottlieb v. Northriver Trading Co., LLC, 58 AD3d 550 (1st Dept 2009), in which the court recognized a common law right of LLC members to seek an equitable accounting remedy.
Matter of Verdeschi, 63 AD3d 1084 (2d Dept 2009), in which the court ruled that the majority shareholders of an accounting firm were liable for the value of the deceased minority shareholder's interest after they formed a new firm using the old firm's assets and good will.
Yemini v. Goldberg, 60 AD3d 935 (2d Dept 2009), in which the court enforced stock ownership rights as reflected in a nominee agreement notwithstanding allegations of unclean hands relating to the concealment of the stock interest.
Matter of Ravitz, 65 AD3d 1049 (2d Dept 2009), holding that the court lacks authority to conduct an appraisal of good will value in post-dissolution proceedings arising from a deadlock petition under BCL Section 1104.
Caplash v. Rochester Oral & Maxillofacial Surgery Associates, LLC, 63 AD3d 1683 (4th Dept 2009), in which the court held that a 50% LLC member lacked authority to hire company counsel to accept the other member's resignation.

Cooperstown Capital, LLC v. Patton, 60 AD3d 1251 (3d Dept 2009), in which the court invalidated a selective capital call that violated the operating agreement's provision for pro rata contributions.
Fuiaxis v. 111 Huron Street, LLC, 58 AD3d 798 (2d Dept 2009), in which the court enforced a capital call to pay legal defense costs in a judicial dissolution proceeding, as authorized by the parties' operating agreement and LLC Law Section 502.
Matter of Jamaica Acquisition, Inc., 25 Misc 3d 1212(A) (Sup Ct Nassau County 2009), a dissenting shareholder appraisal case involving the valuation of former bus companies, in which the court rejected a discount for built-in capital gains.
Watkins v. J C Land Development, Ltd., Index No. 30679-08 (Sup Ct Suffolk County June 19, 2009), in which the court applied judicial estoppel to deny shareholder standing to an ex-convict who concealed his alleged shares from probation authorities at the time of his sentencing.
Ficus Investments, Inc. v. Private Capital Management, LLC, Index No. 600926/07 (Sup Ct NY County Feb. 23, 2009), in which the court, addressing an issue of LLC dissolution procedure, ruled that the dissolution request must be made by complaint or petition, not by "mere" motion in an existing non-dissolution action.

Wishing all my readers a happy, healthy and prosperous New Year.

NY Business Divorce Adds Case Alerts via Twitter

Peter A. Mahler — Wed, 23 Dec 2009 06:00:00 -0500

There's a new twitter module in the sidebar of this blog. The module displays my most recent tweets and provides a link for anyone who'd like to follow me. My tweets will be devoted primarily to short descriptions of, and links to, newly released court decisions of interest to business lawyers and other professionals.

For some time I've been following the twitter phenomenon from afar, with a special interest in how it's being used by lawyers. The overwhelming majority of what I see strikes me as piffle, although, according to everything I read in the blogosphere, I'm missing the point of social media. Clueless though I may be, I pledge not to tweet about my lunch-time tuna fish sandwich or pass on platitudes about life lessons lifted from Bartlett's Quotations.

On the other hand, I've become convinced that the immediacy, format and accessibility of twitter, if used intelligently, can serve a highly useful purpose. Effective tweeting for professionals, like effective blogging, is about adding value. For many years I've regularly scanned the online decisions posted daily by the New York courts during the week. I also follow numerous law blogs and other secondary legal resources. If I can filter, interpret and repackage some of that information to make it more readily available to others, that's value added.

So I encourage you to follow me on twitter if you'd like any easy way to keep abreast of breaking decisions -- but not if you're looking for piffle.

Two-Member LLC Operating Agreement Contains Recipe for Dissension and Litigation

Peter A. Mahler — Mon, 21 Dec 2009 06:00:00 -0500

Last month, in Lola Cars International, Ltd. v. Krohn Racing, LLC, No. 4479-VCN (Del. Ch. Nov. 12, 2009), Vice Chancellor John W. Noble of the Delaware Court of Chancery issued a 31-page letter opinion addressing a number of important issues, including the adequacy of a deadlock dissolution claim, in a dispute involving a two-member Delaware LLC that built and sold Daytona-class Lola race cars (pictured). The case is noteworthy in the business divorce arena for two reasons, one spot-lighted by the decision and the other further off-stage.

The plaintiff, Lola Cars International, Ltd. ("LCI"), as 51% member teamed with defendant Krohn Racing, LLC ("Krohn"), as 49% member, to form Proto-Auto, LLC ("Proto") to manufacture and sell Grand Am Series professional race cars. Despite LCI's majority interest, under Proto's operating agreement the two members were equally represented on its governing board. As one of Krohn's primary obligations under the Operating Agreement, it agreed to provide the services of its manager, Jeff Hazell, as Proto's chief executive officer. LCI and Krohn had a falling out within the first two years of their venture, prompting LCI to sue for dissolution.

Center stage in Lola is Vice Chancellor Noble's analysis of the standard for judicial dissolution of LLCs under Section 18-802 of the Delaware LLC Act, which substantially resembles Section 702 of New York's LLC Law in requiring a showing that it is "not reasonably practicable to carry on the business in conformity with" the LLC operating agreement. Lola makes no new law. Rather, it builds on Chancellor Chandler's analysis in Fisk Ventures, LLC v. Segal, 2009 WL 73957 (Del Ch. Jan. 13, 2009) (read my prior post on Fisk with a link to that decision here), summarized as follows in Lola:

The Court in Fisk laid out three factual scenarios this Court should consider when ordering judicial dissolution under Section 18-802's reasonable practicability standard: (1) whether the members' vote is deadlocked at the Board level; (2) whether there exists a mechanism within the operating agreement to resolve this deadlock; and (3) whether there is still a business to operate based on the company's financial condition. The Fisk court explained that none of these factors is individually conclusive, nor must each be found for a court to order dissolution. Rather, they provide guidance to the ultimate inquiry of whether the company can continue to pursue its stated business purpose with reasonable practicability.

In denying a pretrial motion to dismiss the complaint for failure to state a claim, Vice Chancellor Noble found that LCI's allegations satisfied two of Fisk's three criteria. First, the complaint alleged that the two, co-equal managers were irreconcilably deadlocked over replacement of Proto's chief executive officer, Hazell, whom LCI accused of managing Proto more for Krohn's benefit than Proto's. Second, the complaint raised serious doubt whether Proto could continue to operate in its current financial condition which allegedly rendered the company insolvent. In response to Krohn's counter-argument regarding company finances, the Vice Chancellor echoed a theme sounded in Fisk and other dissolution precedents involving LLCs as well as limited partnerships, that the standard for judicial dissolution is not "whether the Company cannot possibly continue its business in accord with the Operating Agreement, but rather whether to do so would be reasonably practicable" (emphasis added).

The Fisk factor not satisfied in Lola, i.e., whether the operating agreement lacks a deadlock-breaking mechanism, is my segue into what I above called the off-stage aspect of the case and the basis for the title of this post. Proto's Operating Agreement did indeed contain a buy-out mechanism in the event of a member dispute or, as Vice Chancellor Noble colorfully described it, a "self-help disentanglement provision." However, as he also noted, the mechanism was entirely voluntary and, predictably, was exercised by neither of the two members. In addition, the Operating Agreement contained a termination clause that could be invoked by either member after a breach of the Operating Agreement by the other. Under this provision, the non-breaching member must notify the other member of the breach as well as the consequences of a failure to rectify the breach which, if not cured within 21 days, authorizes the non-breaching party to terminate the Operating Agreement. Alongside its dissolution complaint, LCI filed a second lawsuit seeking to enjoin Krohn from interfering with LCI's sole management of Proto based on LCI's prior notice of breach given to Krohn and the latter's alleged failure to cure.

What's wrong with this picture? Plenty. First of all, a voluntary buy-out provision, i.e., one that gives neither member the right to put its interest to the company or the other member, is as good as no buy-out provision at all. Second, the termination clause in this case is one of the surest-fire recipes for dissension and litigation I've ever come across. Termination of Proto's Operating Agreement automatically means governance under the Delaware LLC Act's default provisions, which means LCI as 51% owner gains sole control of Proto under Section 18-402. In other words, the termination provision gives LCI a powerful incentive to declare Krohn in breach of the Operating Agreement, and an equally powerful incentive to Krohn to contest any alleged breach. By the same token, the provision is useless to Krohn for the obvious reason that it would not want to gift sole control to LCI by invoking termination based on LCI's breach. No one should be surprised that this venture ended up in Delaware Chancery Court.

It's possible that the termination clause was the quid pro quo for LCI's agreement to give 49% member Krohn equal management rights on Proto's board of managers. Yet there are dysfunctional incentives built into the bargain that render it extremely short-sighted. It's not always easy, but sophisticated business partners with experienced counsel usually are able to devise and include in the operating agreement a workable, compulsory buy-sell agreement that will keep them out of destructive and expensive court proceedings, or at least will limit potential disputes to appraisal issues.

Read here Professor Ribstein's analysis of the Lola case, in which he queries whether the court should have held that the statutory dissolution remedy was foreclosed by the contractual termination remedy.

Delaware Supreme Court Upholds Application of Statute of Frauds to Oral LLC Operating Agreements

Peter A. Mahler — Wed, 16 Dec 2009 10:56:32 -0500

Around a year ago I wrote about Delaware Chancery Court's ruling in Olson v. Halvorsen, in which it held that the statute of frauds applies to oral LLC operating agreements. I pointed out that Delaware's LLC law expressly permits oral operating agreements, whereas New York's LLC law defines the operating agreement as a written agreement. To my knowledge, no New York court has yet grappled with the issue.

The Olson ruling was appealed to the Delaware Supreme Court, which yesterday affirmed Chancery Court's ruling (read decision here). In a posting today on his Ideoblog, Professor Ribstein quotes at length from the decision and offers his always-incisive analysis, including his take on how the Olson ruling might play out in a jurisdiction like New York that requires written operating agreements.

It's an important issue for practicing attorneys who help form and give counsel to LLCs, so if you fall into that category -- or even if you don't -- I recommend you read the Professor's post.

Bankruptcy Court's Ruling Does Not Establish "Floor" Value in Subsequent Stock Appraisal Proceeding

Peter A. Mahler — Mon, 14 Dec 2009 06:00:00 -0500

When bankruptcy interrupts corporate dissolution proceedings, it usually means bad news for the petitioner. For instance, last year I wrote about a petition for corporate dissolution doomed by the petitioner's failure to disclose his stock interest in prior bankruptcy proceedings. A recent decision presents an interesting departure from the norm, involving a dissolution case commenced in 1990 that took a 10-year detour through bankruptcy court before returning to state court to resume a buyout proceeding. The case, Smith v. Russo, 2009 NY Slip Op 32785(U) (Sup Ct Queens County Nov. 13, 2009), raised the question whether the bankruptcy court's basis for rejecting as inadequate a buyout settlement proposed by the bankruptcy trustee should be given collateral estoppel effect -- for the benefit of the former bankrupt -- in the subsequent state court valuation proceeding.

Husband and wife Richard and Nelsi Smith were 27.5% shareholders of Meadow Mechanical Corporation formed in 1980. In 1990, the other shareholders removed Richard as president and barred both Smiths from the business premises, prompting the Smiths to sue for dissolution under Section 1104-a of the Business Corporation Law. The other shareholders then elected to purchase the Smiths' shares for fair value under BCL Section 1118.

The case fell into a six-year quagmire featuring an initially successful, contested revocation of the buyout election due to the bankruptcy of one of the purchasing shareholders, followed by a reversal on appeal. Then, in 1996, petitioner Richard Smith filed for bankruptcy. The dissolution proceeding and a separate action against Meadow on a $275,000 promissory note were the only assets of the debtor's estate. The trustee in bankruptcy asked the bankruptcy court to approve a $350,000 settlement for both matters, which Smith and the creditors opposed.

The bankruptcy court held an evidentiary hearing including testimony by accountants for the trustee and Smith, and by the accountant who prepared Meadow's financial statements. In its decision, the court approximated Smith's share of the company earnings to be $300,000 and, after applying an earnings multiplier and discount for lack of marketability, concluded that "the value of the Debtor's interest in Meadow would most likely increase to no less than $600,000." On that ground the court in 2003 entered an order denying the trustee's motion to approve the settlement, stating that the proposed settlement "does not adequately reflect the value of the Dissolution Action and the note owed to the Debtor's estate."

The trustee appealed to the federal district court which affirmed the bankruptcy court's ruling in 2005, following which the bankruptcy court authorized the trustee to abandon to the debtor the claims of the debtor against any party. In 2006 -- 16 years after the action started -- the state court restored the valuation proceeding to active status.

The Smiths then sought to leverage the bankruptcy court's order by moving for partial summary judgment in the valuation proceeding. Their motion asked the state court to rule on the basis of collateral estoppel that the minimum value of their Meadow shares was $600,000 for Richard's shares and a proportionate amount of $133,333 for Nelsi's shares. In other words, they wanted the court to set a $733,333 floor for the combined value of their shares, subject to their offering evidence at a later hearing of an even higher value.

For the uninitiated, collateral estoppel, also referred to as issue preclusion, is based upon the general notion that a party, or one in privity with a party, should not be permitted to relitigate an issue decided against it. The party seeking the benefit of collateral estoppel must prove (1) that the identical issue was necessarily decided in the prior action and is decisive in the present action, and (2) that the party to be precluded from relitigating an issue had a full and fair opportunity to contest the prior determination.

The decision by Queens County Supreme Court Justice Peter J. Kelly found that the Smiths satisfied neither of the two required elements. With respect to identity of issues, Justice Kelly stated that the issue before the bankruptcy court under federal bankruptcy law was whether the trustee's proposed settlement "fell below the lowest point in the range of reasonableness," whereas the issue in the state court valuation is "what is actually the proper full value of the plaintiff's shares in Meadow." Justice Kelly elaborated:

At most, as part of its inquiry into the reasonableness of the proposed settlement, the bankruptcy court resolved the issue of what was the minimum reasonable value of the plaintiff's shares in Meadow. This court need not resolve that issue in a dissolution proceeding, but rather must determine the actual, full value of the plaintiff's shares. . . . The figure arrived at by the bankruptcy judge as the minimum reasonable value of the plaintiff's shares was just an estimate. The bankruptcy judge expressly noted that her function was merely to "canvass" the issues in the underlying litigation, "not to decide the issues of fact and law " raised therein. The bankruptcy judge speculated about the weight this court would give to certain financial documents, and stated in a tentative manner: "For the sake of argument, this court would reduce the Debtor's interest in Meadow to $300,000." (Italics added.). The bankruptcy judge did not take evidence on the crucial matter of the "multiplier" to be applied to the $300,000 in estimated earnings, but merely picked a conservative number suggested by other cases.

On the second element, Justice Kelly found that the other Meadow shareholders did not have a full and fair opportunity to litigate the issue pertaining to the minimum value of Smith's interest in Meadow. "They were not parties to the bankruptcy proceeding," wrote Justice Kelly, "and the only parties to the motion for an order approving the proposed settlement were the trustee in bankruptcy, Smith, and creditors who opposed the proposed settlement." Nor were the other shareholders in privity with the trustee.

Justice Kelly's discomfort with the Smiths' application went further. The Smiths were trying to set a valuation floor from which the ultimate determination of value could only go higher. This approach, however, left open the possibility of a state court determination "inconsistent" with that of the bankruptcy court. As Justice Kelly further explained:

[Smith's] procedural maneuver does not advance the policies underlying the doctrine of collateral estoppel, one of which is the prevention of inconsistent decisions by different courts. This court may, for example, find a different multiplier, if any, to be appropriate, thereby drastically altering the value up or down to be placed on Smith's shares. Moreover, conservation of resources, the other policy consideration underlying the doctrine of collateral estoppel, will not be promoted in this case where the issue of valuation will have to be tried de novo. [Citations omitted.]

The decision mentions Smith's allegation that, in connection with his bankruptcy, the other shareholders initially offered $400,000 to the trustee and subsequently $350,000 for Smith's interest in Meadow. One can speculate that the other shareholders might have been able to conclude the case then and there had they formally intervened in support of the trustee's motion to approve the settlement, and had they offered a full-fledged, expert appraisal bolstering the fairness of the amount. At least from a collateral estoppel standpoint they would have been no worse off for trying based on Justice Kelly's analysis of the differing, substantive standards in the bankruptcy and state court valuation proceedings.

Interview with Law Professor Larry Ribstein on his New Book, "The Rise of the Uncorporation"

Peter A. Mahler — Mon, 07 Dec 2009 06:00:00 -0500

If you've ever studied partnerships or limited liability companies, chances are you know of Professor Larry Ribstein, the Mildred Van Voorhis Jones Chair in Law at the University of Illinois College of Law. In fact, the same can be said for securities law, choice of law, jurisdictional competition, the portrayal of business in film, the law business, and a host of other topics that come under his penetrating analysis. Professor Ribstein is co-author of the leading treatises on LLCs and partnerships along with two business associations casebooks, and he has written or co-authored about 140 articles. His ABA Top-100 blog (Ideoblog.org) addresses legal and economic issues of interest to lawyers and the business world on a daily basis. His books include The Sarbanes-Oxley Debacle and The Constitution and the Corporation (both with Henry Butler), The Law Market (with Erin O'Hara) and The Economics of Federalism (with Kobayashi).

To this vast ouevre Professor Ribstein now adds his latest book published by the Oxford University Press, entitled The Rise of the Uncorporation. The book covers the history, law and finance of unincorporated firms which, since LLC enabling statutes swept the country in the early 1990's, have become the dominant business form for non-publicly traded companies, and are poised to enter the large-firm realm of private equity, hedge funds and publicly traded partnerships (e.g., Chrysler LLC). Professor Ribstein's book identifies competition between the states and among business forms to constrain regulatory excesses as one of many reasons for the growing dominance of the "uncorporation." For anyone interested in this area of law, it is must reading.

I'm fortunate that Professor Ribstein agreed to answer some questions about his book and related topics for this blog. The Q&A follows. Enjoy.

Mahler: Congratulations on your new book, The Rise of the Uncorporation, which you describe in your introduction as "the first general theoretical and practical overview of alternatives to incorporation." Since my practice deals mostly with closely held business firms, my first questions are whether the issues and themes you develop in the book divide into two separate universes, one for the large, publicly owned firm and another for the smaller, owner-managed companies, and whether the problems engendered by the corporate form are greater for one than the other?

Ribstein: The fundamental distinction I make in the book is between corporations and what I call "uncorporations" -- that is, partnerships and other business forms such as the limited liability company that are based on the partnership. So, no, I do not think that publicly held firms are in a separate "universe." However, large uncorporations, such as publicly traded partnerships and private equity and hedge funds, raise separate issues. I deal with those issues in Chapter 8, as discussed below in answer to your question about the "architecture of corporate law." The corporate form can raise significant problems for both types of firms.

Mahler: Your book points out that, prior to the Industrial Revolution, when the need for centralized management, limited liability and large pools of capital spurred the rise of the corporation, business associations in the United States were dominated by the partnership and joint stock company, whose management structure and flexibility are more akin to the modern limited liability company. Why, over 100 years after its triumph, is the pendulum swinging away from the rigid corporation and back to a contract-based form?

Ribstein: There are separate stories for small and large firms. Partnership-type forms always were appropriate for closely held firms. However, small firms that wanted limited liability were confined by tax and other laws to the close corporation form during the second half of the 20th century. I discuss in Chapter 6 how the "LLC revolution" broke down these barriers. The corporate form was arguably appropriate for larger firms, though the joint stock company also could have been adapted to this use as it was in England. Chapter 8 discusses how a variety of factors, including the development of new governance technologies (particularly private equity), regulation (particularly Sarbanes-Oxley), and a reduced demand for corporate features, have led to increased use of the uncorporation by large firms in the U.S. over the last quarter century.

Mahler: Last time I checked, new LLC filings are outpacing corporation filings everywhere except four of the biggest states accounting for a disproportionately large number of new filings, namely, New York, California, Illinois and Florida. In your book and in your other writings you highlight the importance of state law competition in formation choices. What do you think explains the disparity, and do you see the larger states eventually stepping in line with the rest?

Ribstein: Each state imposes different burdens on different business forms. A few years ago I studied the choice between the LLC and limited liability partnership forms (Ribstein & Kobayashi, Choice of Form and Network Externalities, 43 William & Mary Law Review 79 (2001)) and determined that the LLC dominated except in states where the LLP was tax-favored. I haven't done detailed research on the latest state filing data on LLCs and corporations. However, I believe that the two forms are running fairly close in Florida, and that higher LLC fees likely explain the corporation's lead in New York and Illinois. State competition for business location and formation plays an important long-run role in ensuring that states offer firms an efficient menu of business forms.

Mahler: A 2008 empirical study by Professors Dammann and Schundeln (Where are Limited Liability Companies Formed? An Empirical Analysis, Research Paper (2008) examined the state of formation choices for limited liability companies and reached the conclusion, among others, that LLC's are migrating away from states that offer lower levels of protection for minority investors, which struck me as counter-intuitive because the majority owners presumably have more say in the matter. Your reaction?

Ribstein: My recent paper with Kobayashi, Jurisdictional Competition for Limited Liability Companies, analyzes Dammann and Schundeln's results and tests the role of other factors and comes to very different conclusions. Specifically, we find that the larger LLCs that form outside their home jurisdiction basically are choosing whether to form at home or to form in Delaware. Only a couple of other states host substantial numbers of out-of-state LLCs, and they don't come close to Delaware. We conclude that firms form in Delaware because they want their litigation handled in Delaware's high-quality business courts, not because they are seeking stricter or laxer laws. This is probably the same factor that explains publicly held corporations' jurisdictional choice.

Mahler: In your book you suggest that the "architecture of corporate law" may have contributed to the recent financial meltdown. What do you mean, and are you suggesting that Bear Stearns and Lehman Brothers might still be with us today if they had adopted the uncorporate form?

Ribstein: Chapter 8 of the book discusses how elements of the partnership structure can do a better job in some situations than the corporate form of ensuring that managers act in the owners' interest. These elements include uncorporate managers' significant ownership stake in the firm and the owners' greater access to the firm's cash through distributions and the firm's limited life. I do think that Bear and Lehman's adoption of corporate structures contributed to their downfalls. I also note that the investment banking firm that came through the subprime crash in the best shape -- Goldman Sachs -- had the most partnership-like structure. I don't conclude that investment banking firms necessarily should have remained partnerships, but rather that they should have retained some partnership-like features rather than going all the way from partnership to the standard corporate form.

Mahler: You have a chapter in your book on the problems of the close corporation which you characterize as an "evolutionary dead end" because, as you put it, "the corporate form could not be a satisfactory vehicle for closely held firms." Why is that so, and does the LLC experience over the last 20 years suggest that the problems of closely held firms, particularly the problem of owner lock-in, are any less difficult with that entity form?

Ribstein: The corporate form is designed for large, centrally managed, publicly traded firms. These are the default rules that apply when the parties neglect to make specific contracts, as they often do in closely held firms. Of course the problems of closely held firms do not simply disappear when the firms become LLCs. The owners and courts must balance, among other things, the owners' need to be able to withdraw from the firm to escape majority oppression, the firm's need for permanence, and a variety of tax and regulatory concerns. Although statutory default rules do not always meet a firm's idiosyncratic needs, the LLC does a better job than the corporate form because it is better designed for modern closely held firms, its flexibility better enables firms to tailor the form to their needs, and the continual process of judicial decisions and legislative change, is gradually producing better results than the "evolutionary dead end" of the close corporation.

Mahler: In that same chapter you critique Gardstein v. Kemp & Beatley, 64 NY2d 63 (1984), the iconic New York decision adopting the reasonable expectations test for minority shareholder oppression, which you cite as an example of a court providing ad hoc a contract for the parties who have not made one for themselves. Others would argue that the judicial function entails exactly that kind of ad hoc decision-making based on the specific facts of each case, necessarily at the expense of some degree of predictability. How would you respond to that argument?

Ribstein: I don't necessarily fault the Gardstein court, but rather the statute the court had to deal with. When parties form a firm that looks like a partnership but yet is organized as a corporation and do not agree over exit, what do they "expect" -- to be treated like the partnership they looked like or the corporation they were? This problem is forced on the courts and the parties by the fact that at the time of Gardstein closely held firms essentially had to incorporate in order to get limited liability. While courts also have to fill gaps in LLCs on a case by case basis, at least closely held firms now can make the court's task easier by choosing more suitable default rules.

Mahler: You also question the fair value standard used in many of the buyout statutes adopted by the states (including New York) as a counterbalance to the minority shareholder's right to seek judicial dissolution of closely held corporations. At the same time you point out that corporation shareholders implicitly opt into the dissolution/buyout statutes when they chose the corporate form for their business. Doesn't that latter point obviate the arguable lopsidedness of the fair value standard, given that the shareholders are always free to contract their own rules, e.g., deeming a dissolution proceeding to be an offer to redeem shares at a predetermined price or formula?

Ribstein: To return to my previous answer, the parties generally can fashion their contracts as they choose, even as close corporations. The problem is that closely held firms do not always engage in elaborate contracting. The best response to this problem is to give the parties the most suitable default rules. As I have said, that means partnership-type rules for closely held firms.

Mahler: I recently posted on this blog an interview with Professor Douglas Moll in which he summarized his view, articulated in his 2005 article in the Wake Forest Law Review, that minority members of LLC's are subject to the same types of abuse as minority shareholders in close corporations and therefore ought to have comparable statutory protection akin to the minority shareholder oppression laws in most states. Do you agree?

Ribstein: I agree with Professor Moll that LLC members may be subject to majority abuse. That can occur whenever there is a penalty associated with exiting the firm, including in general partnerships. LLC statutes are not perfect in this regard. For example, I am uncomfortable with LLC default rules that bar members from dissociating at will, which to some extent were a response to family limited partnership tax rules. But the LLC form, which is very flexible and not hobbled by corporate type default rules, is a better basis for productive evolution of statutory provisions that fit closely held firms than is the close corporation

Mahler: In one of your Ideoblog postings you refer to the "impenetrable murk of NY LLC law" created by cases such as Tzolis v. Wolff (recognizing LLC member's common law right to bring derivative action) and Gottlieb v. Northriver Trading Co. (recognizing LLC member's common law right to equitable accounting). Is your criticism based on separation of powers (which animated the dissenters in Tzolis), or because these common remedies are particularly unsuited to the LLC form, or because they're unsuited to closely held firms in general, or all or none of the above?

Ribstein: I do think that the NY courts have tried to legislate and that this has led to costly unpredictability. The courts need to recognize that even if statute is flawed, commercial dealings have to be based on a solid legal foundation, and that means respecting the court's role vis a vis the legislature. The Delaware courts have done a much better job in this respect, and as I suggested above that has arguably been a factor in Delaware's attracting so many formations of out-of-state LLCs.

Mahler: Thank you, Professor, for taking the time to answer my questions.

Contender to 50% Stock Interest Wins Decisive Round in Battle Over Nominee Agreement

Peter A. Mahler — Mon, 30 Nov 2009 06:00:00 -0500

I previously reported on a March 2009 appellate decision in a case called Yemini v. Goldberg involving a fight over stock ownership in a holding company called ANO, Inc. The appeals court reversed a trial court decision denying Oded Goldberg's application for a preliminary injunction against Ari Yemini. The dispute centered on the enforceability of a Nominee Agreement that identified Goldberg as the "true owner" of a 50% interest in ANO and designated Yemini as Goldberg's nominee to act on the latter's behalf with respect to the acquisition and operation by ANO of what became a two-thirds interest in another company called Candlewood Holdings, Inc. The appeals court held that the Nominee Agreement was an enforceable "declaration of trust" notwithstanding that Goldberg's 50% interest never was reflected in ANO's corporate records or tax returns, or that other corporate documents including a shareholders agreement expressly identified Yemini as 100% stockholder, or that Goldberg omitted ANO in his net worth affidavit in legal proceedings with his ex-wife.

Now the other shoe has dropped on Yemini. Following the appellate decision Goldberg moved for partial summary judgment prohibiting Yemini from holding himself out as ANO's 100% owner and directing Yemini to issue and deliver certificates to Goldberg's wholly-owned assignee, Goldberg Commodities, Inc., reflecting its 50% ownership of ANO. In addition to the Nominee Agreement, Goldberg offered evidence of his funding of the Candlewood acquisition and a subsequent $1.5 million loan agreement that identified each of Goldberg and Yemini as 50% owners of ANO.

In opposition, Yemini contended that the Nominee Agreement was subject to a verbal agreement conditioning its effectiveness on Goldberg investing in the Candlewood acquisition. Yemini alleged that the approximately $200,000 Goldberg claimed to have invested in fact was cash provided by Yemini to Goldberg, which Goldberg deposited and then wire transferred to ANO's account, and thus represented Yemini's contribution, not Goldberg's. Yemini also offered a $122,000 promissory note dated over a year later from Goldberg to Yemini, and a letter from Goldberg a few years after that referring generally to a "verbal agreement" surrounding the Nominee Agreement.

The decision dated November 17, 2009 (2009 NY Slip Op 32745(U)), by Nassau County Commercial Division Justice Stephen A. Bucaria, rejected Yemini's contentions as unsupported by any probative evidence, and it therefore granted Goldberg's summary judgment motion. Justice Bucaria found that Yemini offered no documentary proof that he gave the funds to Goldberg, such as a signed receipt, or that Yemini even had the cash available. He found no connection between the promissory note and the funds used to finance the Candlewood acquisition. Justice Bucaria also cited Yemini's testimony that those funds eventually were repaid to Goldberg, and he found that Goldberg's letter referring to a "verbal agreement" reinforced Goldberg's position rather than weakened it. In the letter, Goldberg revoked Yemini's authority as his nominee, which made no sense unless Yemini was Goldberg's nominee in the first place.

Justice Bucaria also faulted Yemini's position for attempting to vary the terms of the Nominee Agreement, writing as follows:

When the parties set forth their entire agreement in a writing, a party may not introduce extrinsic evidence or prior or contemporaneous statements to establish that a different oral agreement exists. (See, e,g., W.W.W. Associates, Inc. v. Giancontieri, 77 NY2d 157, 162) ("Evidence outside the four corners of the document as to what was really intended but unstated or misstated is generally inadmissible to add or vary the writing."); Braten v. Bankers Trust Co., 60 NY2d 155 (refusing to enforce oral agreement that contradicted the terms of the parties' written agreement); Harris v. Hallberg, 36 AD2d 857, 2nd Dept., 2007). Plaintiff's [Yemini] argument is contradicted by the express wording of the ANO Nominee Agreement that states the agreement is effective as of the date of the agreement.

The second issue addressed in the decision is Goldberg's transfer of his 50% interest in ANO to his company, Goldberg Commodities. Goldberg asserted that he wanted the interest to be held by Commodities because the funds for his capital contribution came from Commodities via its lending facility and to take advantage of Commodities' tax situation. Yemini argued that he never would have consented to the transfer because Commodities' pre-existing debt might impair Candlewood's ability to secure outside financing. He also argued that a provision in the Candlewood shareholders' agreement prohibited any transfer of Goldberg's ANO interest without the consent of the third Candlewood investor named Moore.

Justice Bucaria readily dispatched Yemini's objections. First, there was no written agreement with Goldberg, or any provision in ANO's bylaws, that prohibited the transfer to Commodities. Second, Moore testified at the hearing that he had no objection to the transfer so long as Goldberg remained the 100% owner of Commodities.

Re-reading the prior lower court decision by Justice Leonard Austin (who subsequently was elevated to the Appellate Division) denying Goldberg's injunction motion, what comes through is the court's disdain for Goldberg's "unclean hands" based on the concealment of his interest in ANO from his ex-wife and tax authorities. The subsequent appellate reversal paid no attention to those factors in finding that the Nominee Agreement was enforceable in accordance with its plain terms. Perhaps what makes this case different from others in which the courts have refused relief based on somewhat similar circumstances is Yemini's apparent knowing participation in at least some of the artifices.

Beware Unreasonable Restraints on Alienation When Drafting Shareholder and Operating Agreements

Peter A. Mahler — Mon, 23 Nov 2009 06:00:00 -0500

Our English common-law heritage includes what's known as the rule against unreasonable restraints on alienation. Law students first encounter the rule in their property class, where they learn about the abolishment of the feudal "fee tail" which restricted the transfer of real property to a specific line of male heirs. Basically, our laws and public policy strongly favor the right of persons to freely dispose of their property both real and personal. Agreements that place ownership of property in the hands of one person and the right to alienate, i.e., sell or otherwise convey the property, in the hands of another, are unenforceable.

The rule is not absolute. It only prohibits unreasonable restraints on alienation. For instance, where a niece agreed to pay $15,000 to her uncle and aunt for a $100,000 farm that was in the family for generations on condition that, during the uncle's and aunt's lifetimes, the niece wouldn't mortgage the farm or convey it to her husband, a court enforced a reversion clause in the recorded deed giving the property back to her relatives when the niece placed mortgages on the farm that subsequently were foreclosed. The court found it reasonable to enforce the restraint to preserve family ownership of the farm for a limited duration. Moreover, the niece's interest in free alienation was outweighed by her agreement to the restraint in consideration for a drastically reduced price. (Example taken from Alby v. Banc One Financial, 128 P3d 81 [Sup. Ct. Wa. 2006].)

What's this got to do with shareholder and operating agreements?

As mentioned, the rule also applies to personal property. Certificated and uncertificated shares in a corporation are considered personal property as are membership interests in a limited liability company (see LLC Law Section 601). One of the main purposes of shareholder agreements for closed corporations and LLC operating agreements is to restrict the transfer of shares and membership interests. Sometimes the restrictions are designed to keep ownership in the family if it's a family-owned business. More generally, such restrictions emulate a partnership model in which the owners are actively involved in company management and therefore need to maintain control over the admission of new owners.

Restrictions that effectively prohibit share transfer are not enforceable. As New York's highest court stated in Wildenstein & Co. v. Wallis, 79 NY2d 641 (1992), factors in assessing reasonableness of the restriction include price, duration and purpose. For example, in Lam v. Li, 222 AD2d 290 (1st Dept 1995), the court invalidated a provision giving one party a perpetual option to purchase 50% of the corporation's shares for $10. In Rafe v. Hinden, 29 AD2d 481 (2d Dept), aff'd, 23 NY2d 759 (1968), a stockholder successfully invalidated a provision requiring him to get written permission from the other stockholder before selling to a third party where the other shareholder retained the arbitrary power to forbid a transfer.

The seminal New York case cited in support of stock transfer restrictions is Allen v. Biltmore Tissue Corp., 2 NY2d 534 (1957), where the court upheld a bylaw provision that gave the corporation the option to purchase the shares of a deceased shareholder at their original purchase price, which was below market value at the date of death. The court explained (citations omitted):

As the cases thus make clear, what the law condemns is, not a restriction on transfer, a provision merely postponing sale during the option period, but an effective prohibition against transferability itself. Accordingly, if the by-law under consideration were to be construed as rendering the sale of the stock impossible to anyone except to the corporation at whatever price it wished to pay, we would, of course, strike it down as illegal. But that is not the meaning of the provision before us. The corporation had its option only for a 90-day period. If it did not exercise its privilege within that time, the deceased stockholder's legal representative was at liberty to "dispose of said stock as he [saw] fit" (§ 30), and, once so disposed of, it would thereafter be free of the restriction. In a very real sense, therefore, the primary purpose of the by-laws was to enable a particular party, the corporation, to buy the shares, not to prevent the other party, the stockholder, from selling them.

Generally speaking, these restrictions are employed by the so-called "close corporation" as part of the attempt to equate the corporate structure to a partnership by giving the original stockholders a sort of pre-emptive right through which they may, if they choose, veto the admission of a new participant. Obviously, the case where there is an easily ascertainable market value for the shares of a closely held corporate enterprise is the exception, not the rule, and, consequently, various methods or formulae for fixing the option price are employed in practice e.g. book or appraisal value, often exclusive of good will, or a fixed price, or the par value of the stock. In sum, then, validity of the restriction on transfer does not rest on any abstract notion of intrinsic fairness of price. To be invalid, more than mere disparity between option price and current value of the stock must be shown.

The restriction upheld in Allen, triggered by the shareholder's death, is akin to a more general right of first offer found in many shareholder and operating agreements. These provisions require a shareholder or member who seeks to exit during his or her lifetime to offer the shares or membership interest back to the corporation/LLC, or to the other shareholders/members, before selling to a third party. The typical first offer provision requires the offerees to accept or decline the offer within a reasonable period (e.g., 30 to 60 days) and uses any of a variety of pricing mechanisms including fixed price, formula, or various appraisal procedures.

The right of first offer should not be confused with the right of first refusal, also commonly found in shareholder and operating agreements. Under the right of first refusal, a shareholder or member may solicit and accept a bona fide purchase offer from a third party, subject to the corporation's or LLC's (or their owners') pre-emptive right to acquire the interest at the same price. The right of first refusal generally is less susceptible to challenge under the rule against unreasonable restraints on alienation because the pricing necessarily is at market value.

A very recent example of a transfer restriction running afoul of the rule is found in Verderber v. Commander Enterprises Centereach, LLC, Short Form Order, Index No. 007691/09 (Sup Ct Nassau County Oct. 15, 2009), decided by Nassau County Commercial Division Justice Ira Warshawsky. Verderber involves a complicated fact pattern with multiple LLCs and operating agreements, in which the primary issue for pretrial decision was the applicability of an arbitration clause -- the court found that the clause applied but was waived by the parties' litigation conduct. Also at issue was the operating agreement's provision that, in the event any member desires to transfer all or any part of his or her interest, it must be transferred to the LLC at a price based on a specified multiple of the company's net operating income, less the current mortgage balance, payable over five years. The plaintiffs (husband and wife), who wanted to transfer their combined 20% membership interests to another LLC wholly owned by them, sought a declaration that the restriction violated the rule against unreasonable restraints on alienation. The defendants, who held the other 80% interests, asked the court for a preliminary injunction to prevent the transfer pending the litigation.

Justice Warshawsky denied the requested injunction on the ground that the defendants were unlikely to succeed in showing that the transfer restriction could overcome the rule against unreasonable restraints on alienation. Here's the pertinent part of the decision:

A provision in a certificate of incorporation requiring a shareholder to give a "first option" to the corporation or the other shareholders to purchase the stock, at an agreed price or then-existing book value, before offering it to outsiders is ordinarily enforceable (Allen v. Biltmore Tissue Corp., 2 NY2d 534, 541 [1957]). However, the option must be for a limited period. "[O]wnership of property cannot exist in one person and the right of alienation in another" (Id. at 542). "An effective prohibition against transferability itself" is not enforceable (Id.). A limited liability company bears resemblance to a close corporation, at least as to the limited liability feature. Thus, it appears that an operating agreement covering a limited liability company may contain a first option provision, but it may not prohibit a member from selling his interest to a third party. In any event, defendants have not shown a likelihood of success on the merits with respect to the enforceability of the provision restricting transfer of plaintiffs' membership interest.

The decision does not quote the defective provision, so it's not 100% clear what went wrong with it. The decision's language suggests that the transfer restriction contains an outright prohibition on a sale of membership interest to anyone other than the LLC. The court's reference to a time limitation also suggests that the LLC may have been able arbitrarily and indefinitely to delay purchase.

I'm aware of only one other decision, by a Georgia state court in a case called RTS Landfill, Inc. v. Appalachian Waste Systems, LLC, 598 SE2d 798 (Ct App Ga 2004) (written up by L. Andrew Immerman in the March 2005 Pubogram), applying the rule against unreasonable restraints on alienation to invalidate a transfer restriction involving an LLC membership interest. Keep in mind, Section 603 of New York's LLC Law states that an LLC membership interest may be assigned in whole or in part "except as provided in the operating agreement." Does the statute arguably trump the common law rule, such that an operating agreement could prohibit outright the transfer of a membership interest? Given New York case law developments applying other common law rules to LLCs such as derivative action and equitable accounting, and finding void as against public policy a waiver in the operating agreement of the right of judicial dissolution, one might predict a similarly victorious outcome for the pro-alienation common law rule. I'd love to see how Delaware Chancery Court would handle the issue under that state's LLC Act which expressly states, in Section 18-1101(a) and (b), that the "rule that statutes in derogation of the common law are to be strictly construed shall have no application to this chapter," and that "it is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements."

Valuing Shares in a Residential Co-op Corporation: Is the Whole Worth More Than the Sum of its Parts?

Peter A. Mahler — Mon, 16 Nov 2009 05:00:00 -0500

The residential co-operative corporation is a strange breed of closely held business entity. In New York, the co-op is formed as a for-profit corporation under the Business Corporation Law (BCL), yet it doesn't operate for profit in the traditional sense of returning cash dividends to shareholders. Instead, ownership of co-op shares entitles the shareholder to occupancy of an apartment under an appurtenant long-term proprietary lease. The co-op's income derives mostly if not entirely from tenant-shareholder maintenance payments, the level of which is designed merely to cover the common charges for building expenses. The market value of the shares held by individual shareholders within the same co-op can vary greatly, not just due to the number of shares allocated to the particular apartment, but also due to the unique characteristics of the apartment.

One of the consequences of being a for-profit corporation is that co-ops in New York are subject to the same statutes governing voluntary and involuntary dissolution as any other closely held business corporation, including BCL Section 1104-a authorizing a petition for judicial dissolution by an "oppressed" minority shareholder holding at least 20% of the corporation's shares. At least in New York City, where co-ops tend to have many apartments, the shares usually are too widely dispersed for any single tenant-shareholder to own 20%. In addition, and with all due respect to noise and odor complaints, the idea of a co-op dweller being oppressed by her neighbors is a far cry from the usual freeze-out/squeeze-out scenarios involving loss of employment, removal from the board, financial abuse by the majority, and lack of a market exit.

The fact is, however, that New York City also has many smaller co-op buildings such as converted townhouses and brownstones featuring four or five apartments, each of which may be allocated 20% or more of the co-op's shares. And, New York City being a litigious kind of town when it comes to expensive real estate (think Trump), it's inevitable that an alienated tenant-shareholder in such a co-op would opt to bring a dissolution proceeding instead of exiting by selling her apartment on the open market. A rational shareholder presumably would do so only if she believes she'll get more value from a liquidation of the corporation's assets than from selling her apartment, i.e., that the value of the entire building is greater than the sum of its parts.

That appears to be the theory behind the dissolution petition by a 20% co-op tenant-shareholder named K.C. McDaniel in McDaniel v. 162 Columbia Heights Housing Corp., 2009 NY Slip Op 29390 (Sup Ct Kings County Sept. 29, 2009), recently decided by Kings County Commercial Division Justice Carolyn E. Demarest. The case involves a multi-faceted dispute between McDaniel and her fellow apartment owners of a five-unit co-op (pictured above) located on a beautiful street in Brooklyn Heights near the promenade facing the lower Manhattan skyline. Readers of this blog may recall my April 2009 post reporting on a prior ruling in the McDaniel case involving interpretation of the co-op's bylaws. The prior post noted that the non-petitioning shareholders had exercised their right under BCL Section 1118 to purchase McDaniel's shares for "fair value" and thereby avoid adjudication of the oppression claim. In the latest decision, Justice Demarest is presented with radically different valuation approaches in which, on the one side, McDaniel asks for her pro rata share of the building's value based on its "highest and best use" as a single family residence without regard to the legal impediments posed by the existing proprietary leases and, on the other side, the respondents ask that McDaniel be awarded the appraised value of her apartment.

[Note: If you read Justice Demarest's lengthy decision you'll see that most of it is taken up with a complex factual recitation and analysis relating to a companion lawsuit between the same parties in which McDaniel sued to recover almost $800,000 arising primarily from the defense and settlement of a prior litigation with a former tenant-shareholder. I'm not going to address this aspect of the case, other than to speculate that the existence of significant money claims may help to explain as a tactical matter McDaniel's decision to sue for dissolution rather than sell her apartment on the open market.]

In her prior ruling on the bylaws, Justice Demarest preordained that the fair value of McDaniel's interest will "largely depend on the appraisal value of the building at the valuation date, but will also include any other assets, such as bank accounts, less any liabilities such as debts of the Corporation." In her latest decision, she elaborated that "there is no profit in the operation of the Corporation, the only purpose of which is to provide housing for the five tenant shareholders" each of whom was allocated the same number of shares; that the only "return" on their investment is use of their apartment and the possibility of profit upon sale; that the share valuation "is logically the net asset value of the Corporation as a whole on the valuation date"; and that "[m]arket value is clearly implicated in this analysis as the value of the Corporation's primary asset, the Building,will depend upon appraisal of its value on the valuation date."

At the valuation hearing, each side presented expert testimony by a licensed real estate appraiser, neither of whom stayed within the confines of the court's valuation guidelines. McDaniel's expert concluded that the building was worth $5.6 million based on comparable building sales assuming a "gut renovation" of the building to achieve its "highest and best use" as a single family residence, i.e., unencumbered by the existing proprietary leases. The expert also commented that "the sum of the parts is worth less than the whole." Here's what Justice Demarest wrote in rejecting this approach as a measure of fair value:

Petitioner owns a twenty percent interest in a building which is subdivided into five dwelling units. The Corporation is encumbered in its use of the Building by proprietary leases granting occupancy well into the future. It is not reasonable or fair to suggest that the respondent shareholders should be forced to vacate their homes in order to sell the Building vacant so as to afford petitioner the maximum possible return on her investment. Given the nature of the Corporation as a residential co-operative, measuring the "fair value" of a single occupant's interest based upon the highest and best use of the entire structure is not appropriate. A more flexible standard is needed. . . . To mandate that an asset be sold in order to maximize value, so as to put the Corporation out of business, would be contrary to law.

The respondents' expert fared no better. Rather than valuing the building, he appraised McDaniel's apartment alone as of the valuation date, using comparable apartment sales to arrive at a value of $734,000 net of broker's commission and transfer taxes, which he further discounted to $550,000 for the "detrimental effect on marketability of the pending litigation." This methodology, however, ignored Justice Demarest's explicit direction to value the shares based on the market value of the building as a whole. In her own words:

This Court rejects respondents' attempt to establish the fair value of petitioner's shares based upon the market value of her apartment alone, as such measure fails to account for other assets and liabilities of the Corporation. Petitioner is the owner of 400 shares of the Corporation, the fair value of which must be ascertained upon the value of the Corporation as a whole on the valuation date.

Justice Demarest also rejected respondents' reliance on an appellate court precedent, Matter of Balk (125 West 92nd Street Corp.), 24 AD3d 194 (1st Dept 2006) (read here), which affirmed a trial court's valuation of a 30.75% stock interest in a four-apartment Manhattan co-op corporation (read here). In Balk, both sides submitted appraisals of the market value of the petitioner's apartment. "While most instructive," Justice Demarest remarked, " the case did not implicate competing standards of valuation."

The circumstances thus required Justice Demarest to arrive at her own valuation of McDaniel's shares, which she did by valuing the building as a whole at $4,250,000 based on the $850,000 sale one year earlier of another of the subject co-op's five apartments which also was allocated one-fifth of the corporation's shares. As a reality check, Justice Demarest relied on a comparable $8 million sale (which translated to $741 per square foot) of a nearby but larger apartment building "similarly burdened with tenancies that are not easily terminable." The $741 per square foot price translated to a value of $4,342,260 for the subject co-op's building. (I interpret the court's reference to "similarly burdened with tenancies" as meaning the comparable building was not a co-op but was occupied by rent stabilized or rent controlled tenancies. I've never heard of an occupied co-op building being sold.)

The court's final tally of the amount due McDaniel for her shares came to $839,760.68, computed as one-fifth of the corporation's value of $4,257,755 ($4,250,000 for the building plus cash deposits less liabilities) less deductions for unpaid maintenance charges of about $11,000. Justice Demarest refused to apply a discount for the pending litigation, as requested by respondents, although she did say that any effect the litigation had on value was offset by the general rise in market values between the 2006 sale of the other apartment for $850,000 and the valuation date in May 2007. Justice Demarest also rejected McDaniel's argument for a surcharge against the respondents for failing to make building repairs.

In case you're wondering about the mechanics of the buyout, the decision notes that McDaniel previously vacated the apartment which therefore was available to be immediately marketed for sale. Justice Demarest directed the parties to submit proposed terms of sale and ordered that, "barring a different agreement between the parties, it is expected that the Corporation will either obtain a mortgage on the Building in order to pay the full value of petitioner's shares or will attempt to sell the apartment in order to fund payment to petitioner." The court's order also mandates that the apartment's $1,000 per month maintenance charges pending the completion of the buyout be deducted from the amount due McDaniel, so, depending how long the process takes and what problems with a financing or sale are encountered, it wouldn't surprise me if these litigious former neighbors aren't done fighting.

The Importance of Identifying Your Client -- And Who's Not Your Client -- When Preparing Shareholder Agreements

Peter A. Mahler — Mon, 09 Nov 2009 06:00:00 -0500

You're an attorney. You're approached by Mortimer who tells you that he recently formed a new business corporation with Archibald, and that they want to hire you to prepare a shareholders' agreement. You also learn that Mortimer is the 51% "money" partner while Archibald is the 49% operating partner.

You've prepared many a shareholders' agreement, and you know that the interests of Mortimer as majority owner and Archibald as minority owner inherently are in conflict on diverse management and financial issues, not to mention restrictions on stock transfer and redemption. Should you represent both Mortimer and Archibald, or only one of them? The disparate financial wherewithal and contributions of the two partners only accentuates the conflict. If you represent Mortimer alone, and Archibald has no attorney of his own, is that a problem?

The rules of professional ethics set forth standards and proscriptions governing the simultaneous representation of multiple clients with conflicting interests. Under the right circumstances, with appropriate client counseling and disclosure, it may be ethically acceptable to represent both Mortimer and Archibald in the preparation of the shareholders' agreement. In all events, it is vitally important that the attorney identify and document exactly whom they're representing -- and whom they're not representing -- in these situations. The lawyer who fails to do so is taking on risk of a subsequent lawsuit by a disappointed shareholder for malpractice or fiduciary breach.

That's pretty much what happened in Schlissel v. Subramanian, 2009 NY Slip Op 52188(U) (Sup Ct Kings County Oct. 26, 2009), decided by Kings County Commercial Division Justice Carolyn E. Demarest. The plaintiff, Schlissel, and the defendant, Wasan, decided to buy a Dunkin' Donuts franchise in Brooklyn. Wasan, the money partner, was to own 75% and Schlissel the remaining 25% in consideration of past services and for helping Wasan legalize the franchise. In early 2002, Schlissel contacted attorney Van Epps to form a new corporation to acquire the franchise. Van Epps' initial engagement letter named Wasan as the client and made no mention of Schlissel. Some months after forming the corporation Van Epps also prepared bylaws, stock certificates and tax documents reflecting the 75%/25% ownership, which Schlissel and Wasan jointly executed. In this same time period Van Epps met with Schlissel on at least two occasions in connection with setting up the corporation.

In early 2003, Van Epps proposed to Wasan (but not to Schlissel) that Wasan capitalize the company with $725,000 of which about $90,000 would be loaned to Schlissel for her contribution while reducing her ownership to 12.5%. Wasan agreed. Van Epps prepared a shareholders' agreement, new stock certificate and promissory note, all dated "as of" February 1, 2003, reflecting Wasan and Schlissel as 87.5% and 12.5% shareholders, respectively. Van Epps sent the documents to Wasan with a note stating that he should

review this [shareholders'] agreement with Jeanne Schlissel and advise if any additional changes are required. As I mentioned in our meeting, Jeanne should hire an attorney to review this agreement and the note on her behalf.

Van Epps also prepared another engagement letter dated February 5, 2003 to be signed by Wasan as the client and by Schlissel as consenting to Van Epps' representation of Wasan. The letter stated:

I am pleased to represent you in connection with the preparation of a shareholders agreement for Tim & Tab Donuts, Inc.

[After stating the terms of the engagement, the letter continued:] If you agree with the foregoing terms, please indicate by signing below and returning a copy of this letter to me at the above address. Please ask Jeanne Schlissel to sign below indicating her approval of my representation of you.

Immediately above the signature line reserved for Schlissel, the letter stated:

With my signature below, I hereby consent to your representation of [Wasan] in connection with the preparation of a Shareholders Agreement for Tim & Tab Donuts, Inc. and other matters when and as requested by him.

Schlissel and Van Epps disputed the timing of these events. According to Schlissel's complaint, Wasan brought the corporate documents to her home on February 1, 2003, where she signed them. Schlissel contended that she signed the corporate documents "without having the opportunity to discuss them with Van Epps" because she believed that

as my attorney Mr. Van Epps was protecting my interests. At no point prior to my execution of the [corporate documents], did Mr. Van Epps communicate with me in any manner concerning these documents, in no way did he suggest that any material change in the corporation was occurring, nor did he remotely hint that a notable change effecting [sic] me was in view.

Several days later, she further alleged, she received the February 5 engagement letter and also got a "curt" phone call from Van Epps telling her that he no longer represented her and that this was "in her best interests".

Van Epps contended that Schlissel signed the corporate documents after she signed the February 5 engagement letter, and he denied having the telephone conversation.

Approximately five years later -- apparently, Schlissel's annual K-1 tax forms until 2008 continued to show her with a 25% interest -- Schlissel sued Wasan and Van Epps, among other claims, for breach of fiduciary duty in connection with the dilution of her stock interest from 25% to 12.5%. As summarized by Justice Demarest, Schlissel asserted that Van Epps "unilaterally advanced Wasan's interests over those of plaintiff, that he prepared certain corporate documents for the purpose of diluting and diminishing plaintiff's interest in [the company], and that he concealed material information from plaintiff concerning the adverse contents of these documents."

Van Epps moved to dismiss the claim, arguing that he was not Schlissel's attorney and therefore owed her no fiduciary duty. He pointed to the initial 2002 engagement letter which stated that Wasan was his client and, by implication, that he was not representing Schlissel. Justice Demarest observed that "[t]here is no set of rigid rules that must be followed to form an attorney-client relationship" which "may exist without an explicit retainer agreement or payment of fee." Rather, the "court must look to the actions of the parties to ascertain the existence of such a relationship . . . bearing in mind that plaintiff's unilateral belief does not confer upon her the status of defendant's client."

Applying this standard, and assuming the truth of Schlissel's allegations for purposes of a motion to dismiss, Justice Demarest found that Schlissel "had reason to believe" Van Epps was her attorney based on the fact that she was the one who first sought him out, her multiple meetings with Van Epps in 2002, and Van Epps' preparation of the initial corporate and tax documents signed by Wasan and Schlissel in April and May 2002.

Van Epps alternatively argued that any attorney-client relationship he had with Schlissel terminated when she counter-signed her consent on the February 5, 2003 engagement letter with Wasan. Justice Demarest disagreed, for two reasons. First, Van Epps' allegation, that Schlissel signed the shareholders' agreement and related documents after expressly consenting to his retention by Wasan, was contradicted by Schlissel's affidavit, and thus raised an issue of fact not resolvable on a motion to dismiss.

Second, under Rule 1.9 of the Rules of Professional Conduct, Van Epps was required to get Schlissel's "informed consent, confirmed in writing," before he could terminate any pre-existing attorney-client relationship with Schlissel while continuing to represent Wasan's interests adverse to Schlissel. According to Justice Demarest,

[t]he cursory "consent" signed by [Schlissel] does not evidence the requisite informed consent to overcome the edict of the Rule. There is no claim that Van Epps met with [Schlissel] or specifically advised her of the conflict of interest implicated in the proposed representation of Wasan alone.

Justice Demarest accordingly denied Van Epps' dismissal motion, finding that Schlissel's complaint "sufficiently alleges that Van Epps represented conflicting interests at the time [Schlissel] signed the corporate documents" and damages resulting from "alleged misconduct by [Van Epps] by his alleged simultaneous representation of adverse interests." Justice Demarest also was careful to note that the "court makes no determination concerning the merits of [Schlissel's] claims, as the motion to dismiss was addressed solely to the sufficiency of her pleadings and affidavits."

New York's highest court, in Matter of Kelly v. Greason, 23 NY2d 368, 375 (1968), opined that an attorney-fiduciary "is charged with a high degree of undivided loyalty to his client." In an earlier decision by Justice Demarest, which she cites in Schlissel, she expanded on that principle in the conflicts setting as follows:

An attorney has a fiduciary obligation to bring to his or her client's attention all relevant considerations when recommending a course of conduct. An attorney who fails to disclose a conflicting representation or circumstance that causes him or her to represent a client with diminished rigor, breaches his or her fiduciary duty to his or her client. (Macnish-Lenox, LLC v. Simpson, 17 Misc 3d 1118 [A], 2007 WL 3086028, *7, 2007 NY Slip Op 52055 [U] [Sup Ct Kings County 2007])

It is not at all unusual for business partners to prefer using a single attorney to set up a new business entity and prepare owner agreements. The level of trust between the partners typically is high at the outset, and the cost of multiple attorneys may be prohibitive. The partners also may be unaware of the conflicting interests involved in putting together a shareholders' agreement. Schlissel is a strong reminder to attorneys who take on such assignment, as the only attorney on the scene, that they should explicitly and unambiguously document who it is they do and don't represent, that if they do undertake joint representation they should carefully explain the potential conflicts and make a record of the same, and that they should obtain the written acknowledgment of any non-represented owner before they undertake legal services that, absent such acknowledgment, could reasonably be perceived as acting on behalf of all.

Interview with Law Professor Douglas Moll, Leading Authority on Shareholder Oppression

Peter A. Mahler — Mon, 02 Nov 2009 06:00:00 -0500

Douglas K. Moll is Professor of Law at the University of Houston Law Center, where he teaches corporate and commercial law, and is one of the nation's leading authorities on shareholder oppression in the closely held business entity. His scholarly writings on the subject have been cited in numerous cases including, in New York, Horning v. Horning Construction LLC, 12 Misc 3d 402 (Sup Ct Monroe County 2006), in which the court relied on Professor Moll's analysis of the impact of the 1999 amendments to the LLC Law on relations between minority and majority members of LLCs.

I've had an occasional correspondence with Professor Moll for a number of years, so when I heard that he and co-author Robert Ragazzo had published a new treatise called The Law of Closely Held Corporations (Aspen Publishing 2009), I figured it would be a great opportunity to pose some questions about his views on shareholder oppression and about his new book. I think you'll find his answers interesting.

Mahler: Professor, how did you get interested in problems of the close corporation and shareholder oppression?

Moll: I practiced at Fulbright & Jaworski in Houston before becoming a law professor. While I was at Fulbright, I worked on several close corporation disputes, including the appeal of a shareholder oppression judgment. I read the briefs and the allegations of “shareholder oppression” and I couldn’t understand the operation of such a doctrine. What happened to the business judgment rule? What happened to employment at will? The area fascinated me and I read every court decision and secondary source that I could get my hands on. That has basically continued for the past fifteen years. I have now written multiple articles on the closely held corporation and the shareholder oppression doctrine; a casebook on closely held businesses, including close corporations; a second casebook on business organizations generally; and a just-published treatise on the law of closely held corporations.

Mahler: Some argue that courts shouldn't give minority shareholders protection they didn't see fit to bargain for when they became shareholders. Your reaction?

Moll: Well, first of all, there are a host of minority shareholders who have no opportunity to bargain before they become shareholders (e.g., shareholders who receive their stock via gift, inheritance, or in a divorce settlement). So denying these shareholders protection for their lack of bargaining doesn’t make sense to me. Second, there are many impediments to effective contracting that make such a position untenable in my mind. A few examples: (1) Because close corporation owners are frequently linked by family or other personal relationships, there is often an initial atmosphere of mutual trust that diminishes the sense that contractual protection is needed. (2) Even if an investor did recognize that planning for dissension was useful, barriers to effective contracting would still exist. In light of the countless ways in which oppressive conduct can occur, it is quite difficult to foresee all (if not most) of the situations that may require contractual protection. This inability to appreciate the universe of potential problems may result in incomplete contracting or, possibly, in no contracting at all. (3) Ex ante contracting is expensive, as it often requires the assistance of an attorney. In fact, effective ex ante contracting may require the services of multiple attorneys -- one (or more) representing the majority's interests, and one (or more) representing the minority's interests. This level of expense may be prohibitive for many small businesses, especially at their inception. I discuss these and other arguments in the treatise referenced above, as well as in an article that I wrote in the Wake Forest Law Review.

Mahler: In Delaware, unless the corporation elects to file as a statutory close corporation, there seems to be little or no remedy for the oppressed minority shareholder. Do you think it's a case of neglect or deliberate policy choice by the Delaware legislature, and do you see it ever changing?

Moll: Even if one elects to file as a statutory close corporation, what is the ex post judicial remedy? There isn’t one. Subchapter XIV of the Delaware General Corporation Law allows parties to contract for protection in advance, but if the parties do not, there is no provision providing for court-ordered dissolution for example. I do think this is a deliberate policy choice by the Delaware legislature, but I don’t think it is due to a hostility toward minority shareholders. I believe the Delaware legislature simply believes that their existing fiduciary duty doctrines and other provisions allowing for contractual protections are sufficient. In a sense, they are right. For example, many oppression lawsuits involve disguised dividend payments to the controlling shareholder or other violations of traditional shareholder rights. Those claims, in my view, are all actionable under Delaware law. They won’t be called “oppression” claims, but they will work as fiduciary duty, illegal dividend, conversion, or similar claims. What may be different about Delaware law is that they do not seem to offer protection to “non-traditional” shareholder rights – such as a right to employment or an active management role in a close corporation – absent a contractual right providing for such. In other states with oppression doctrines, those non-traditional shareholder rights can be protected even in the absence of a contract. It is also not clear whether Delaware would allow for a buyout as a remedy. It is hard to know if this will ever change. It would be interesting to see what Delaware would do with a classic freeze-out dispute in a close corporation, a la Wilkes v. Springside Nursing Home out of Massachusetts. A case like that would really test whether Delaware is serious about not providing special common-law protections for close corporation shareholders.

Mahler: Over the last decade LLCs have become the preferred form of new business entity filings in most states. Are minority members of LLC any more or less prone to majority abuse than minority shareholders of close corporations, and does LLC legislation adequately deal with the issue?

Moll: In my opinion, minority members of LLCs are just as prone to majority abuse as their close corporation brethren. The lack of a market exit and the same principles of majority rule set the stage for possible abuse. Several states provide a dissolution-for-oppression statute in the LLC setting, but such statutes are not as prevalent as they are in the corporation context. Some argue that LLC owners will be more likely to contract for protection because LLC statutes contain far fewer default rules than comparable corporate statutes. The fact that owners may need to contract for governance rules, however, does not mean that they will also contract for protections from abusive majority conduct – a problem that they may not even foresee. I have written somewhat extensively on this LLC and oppression issue in a 2005 Wake Forest Law Review article.

Mahler: You also published an article in the Duke Law Journal weighing the arguments for and against marketability and minority discounts in fair value proceedings tiriggered by oppression lawsuits. Where do you come out on the question?

Moll: This is a hard one to answer succinctly. (In fact, it took me on the order of 80-90 pages in the Duke article that you mention). I’ll just jump to the conclusion: I do not believe that discounts are appropriate in an oppression buyout. Discounts are discussed in great detail in the treatise referred to above as well as in the Duke Law Journal article that you mention.

Mahler: You and your co-author, Robert Ragazzo, have just completed a new treatise called The Law of Closely Held Corporations. Why did you write it, and who did you write it for?

Moll: We wrote the treatise because we have been researching, writing, and teaching about close corporations for years, and we have both served frequently as consulting and testifying experts in close corporation disputes (and disputes involving business organizations generally). Although there are some helpful resources out there, we found that a number of recurring and difficult issues are not adequately addressed by existing treatises, and some of those publications have become dated. We decided, therefore, to write a comprehensive and up-to-date treatise for practicing lawyers that would deal with the recurring problems that arise in close corporations and, more importantly, would provide answers and guidance for many of those problems. Plus, we thought it would be fun. After all, what could be more fun than spending two years writing a treatise? Hmmm.

Mahler: Lawyers who form private entities involving multiple owners don't always appreciate the problems that can occur down the road. How does your book help them?

Moll: I am obviously biased, but I believe that the treatise covers all of the major litigation and transactional issues related to the closely held corporation. The treatise discusses the common (and not-so-common) problems that can and often do occur down the road. Perhaps more importantly, the treatise discusses ways to avoid or mitigate those problems. Different jurisdictional approaches to major issues are covered (some in 50-state chart form), and a set of forms is also provided. We attempted to make the materials comprehensive and up-to-date, and it is our hope that practicing lawyers will find them to be useful.

Mahler: Does the book have a section on oppression and other bases for dissolution?

Moll: Yes. One of the largest chapters in the treatise is on oppression. There is another chapter on remedies for oppression and other forms of dissension. There is also a section on deadlock.

Mahler: How about variations in state laws governing closely held business entities -- does your book address them?

Moll: It does. As I mentioned above, we have several 50-state charts on some major issues. Even where there is not a chart, our goal was to provide authority for all of the major jurisdictional approaches to a problem or issue. To this end, the footnotes are extensive and there are references to multiple jurisdictions. The treatise, simply put, is intended to be national in scope.

Mahler: Thanks for taking the time Professor, and I look forward to reading the treatise.

Professor Moll's articles on shareholder oppression are available on the Social Science Research Network (click here for his author page). Click here for more information about the new treatise.

Fired Minority Shareholder's Oppression Claim Not Barred by At-Will Employment Provisions in Shareholders' Agreement

Peter A. Mahler — Mon, 26 Oct 2009 06:00:00 -0500

Some months ago, in a post about the intersection of the at-will employment doctrine and fiduciary duty among shareholders in close corporations, I wrote:

The most common allegation of oppression by minority shareholders involves termination of employment by the controlling shareholders. The Court of Appeals in Matter of Kemp & Beatley noted that obtaining employment is often the main reason for becoming a shareholder in a closely held company that typically pays no shareholder dividends. As I've pointed out before, case law holds that the majority's termination of the minority's at-will employment does not give rise to a wrongful termination remedy under either a contract or tort theory, but it may be oppressive for purposes of seeking judicial dissolution where the shareholder joined the venture with the reasonable expectation of getting and keeping a job.

This principle is vividly on display in a recently decided case called Ambar v. Devington Technologies, Ltd., 2009 NY Slip Op 32373(U) (Sup Ct NY County Oct. 13, 2009), where the court refused to dismiss a petition for involuntary corporate dissolution brought by a minority shareholder whose employment was terminated by the controlling shareholders, notwithstanding at-will employment provisions in their shareholders' agreement.

Devington Technologies Ltd. is a closely held New York corporation in the business of providing financial management computer software and programming to offices of medical providers. In 2002, founder Paul Ambar as 30% shareholder and Gershon and Tibor Klein, as combined 70% shareholders, executed a shareholders' agreement containing fairly typical provisions for election of the shareholders as directors and officers, spending authorization limits, and a right of first refusal ("RFR") fixing stock value at $8,335 per share unless otherwise agreed unanimously.

After five years, due to their dissatisfaction with his job performance, the Kleins attempted to buy out Ambar. They proffered an amendment to the shareholders' agreement reducing the board to two directors and replacing the existing RFR with a provision requiring Ambar to sell his 12 shares to the Kleins for a small fraction of the RFR share value. After Ambar refused to sign the amendment, the Kleins scheduled a special meeting of the stockholders and directors at which Gershon was elected president, Tibor was elected secretary, and Ambar was removed from Devington's board of directors and his employment terminated.

Ambar then filed a petition to dissolve Devington under Section 1104-a of the Business Corporation Law, primarily alleging oppressive conduct based on the Kleins' termination of his employment and their refusal to redeem his shares under the RFR at $8,335 per share. The Kleins opposed dissolution and moved to dismiss the petition, arguing that Ambar had no reasonable expectation of continued employment and a board position due to his at-will status under the terms of the shareholders' agreement. The Kleins also contended they were justified in firing Ambar for poor job performance and for causing Devington to incur major business losses.

The court's decision, by New York County Supreme Court Justice Marilyn Shafer, framed the issue as follows:

In opposition to the dismissal motion, Ambar details a different set of facts as to how and why Devington declined . . .. However, for purpose of the motions, it is not necessary for the court to evaluate or decide who or what triggered the corporate failures. It is sufficient to say that petitioner and respondents present diverse interpretations as to the factors that led the business to lose money, and submit dueling affidavits blaming each other for poor business decisions and incompetent day-to-day management. What is relevant to the court at this juncture is whether the petition sufficiently alleges that respondents, as the directors in control of Devington, engaged in conduct toward Ambar which entitles him to seek a judicial dissolution of the corporation.

Majority conduct is oppressive, Justice Shafer observed, when it "substantially defeats the reasonable expectations of minority shareholders," including the expectation to be actively involved in the company's management and operation. "When majority and minority shareholders can no longer work together in their day-to-day decision-making and management, judicial dissolution becomes an option."

Justice Shafer concluded that Ambar's petition (read here), while "not artfully drafted," sufficiently alleged grounds for dissolution based on the Kleins' termination of his employment. In addition, the Kleins' attempt to buy out Ambar's shares "at a severely discounted price ($125.00 rather than $8,335.00 per share) supports his claim of mistreatment by the majority shareholders and states a ground for involuntary judicial dissolution."

Cases like Devington are an important reminder to owners of closely held businesses of the need to include fair and workable shareholder exit mechanisms in the shareholders' agreement. The type of RFR used in Devington rarely succeeds, for at least two reasons. First, in the probable absence of any outside buyers for the minority interest, neither the minority nor majority can compel a buyout at any price. Second, the share price fixed at the outset almost always is doomed to obsolescence, either on the upside or downside. The shareholder agreements' unanimity requirement for any change in the share price effectively deters any later adjustments as the value of the business grows -- in which event the majority will resist adjustment -- or, as in Devington, shrinks -- in which event the minority will resist adjustment.

There are a number of techniques for overcoming the pricing problem, which in turn can ease mutual acceptance of a compulsory buyout trigger. One of the more popular ones is the use either of a single, independent business appraiser whose valuation is binding on the parties, or each side hiring their own appraiser. In the latter design, the agreement usually will provide for averaging the two appraisals if they fall within a specified range of each other or, if not, the appointment by those two of a third, independent appraiser whose valuation will either be determinative alone or is averaged with the first two, or is averaged with the closer of the first two.

None of the buyout mechanisms is perfect, but all are preferable to the uncertainty, expense and angst of dissolution litigation.

Dissolution Counterclaim Fails to Stall Action for Goods Sold and Delivered

Peter A. Mahler — Mon, 19 Oct 2009 06:00:00 -0500

There are a couple of lessons to be learned from a recent decision by Nassau County Supreme Court Justice Daniel Palmieri in a quirky case called The Woods Knife Corp. v. Eastman Machine Co., 2009 NY Slip Op 32069(U) (Sup Ct Nassau County Sept. 2, 2009).

The first is, a minority shareholder who also does business with the corporation, and who fails to secure safeguards in the shareholders' agreement concerning the commencement of lawsuits by the corporation regarding their business dealings, cannot count on shareholder dissension issues to forestall enforcement of the corporation's commercial rights.

The second lesson is, if you're going to seek involuntary corporate dissolution, you must follow the procedural dictates of Section 1106 of the Business Corporation Law, which requires commencement of a special proceeding by petition and order to show cause with publication and service upon necessary parties including the state tax commission. A counterclaim for judicial dissolution in an existing litigation won't cut it.

The case involves two companies, Woods Knife Corporation and Eastman Machine Company, both formed many decades ago. Eastman, owned by the Stevenson family, manufactures cloth cutting machines. Woods Knife, owned 49% by the Stevenson family and 51% by the Woods family, manufactures blades used in Eastman's machines. The original agreement contained Eastman's pledge to "make every effort" to purchase its blade requirements from Woods Knife, but also permitted Woods Knife to sell to others. Nonetheless, over time Woods Knife became wholly dependent on Eastman for sales of its blades.

The commercial relationship between the two came under stress in recent years due to intense price competition from Chinese blade manufacturers. Eastman claimed that it could no longer sell or resell Woods Knife blades for use in Eastman's machines because of their high cost. Eastman alleged that in its role as minority shareholder and adviser, it attempted to help Woods Knife reduce costs and expand its customer base, but did not succeed due to lack of cooperation by James Woods, the principal and manager of Woods Knife. Eastman offered to purchase James Woods' 51% interest in Woods Knife, but the offer was rejected.

The first litigation salvo was fired by Woods Knife by way of a complaint alleging that Eastman owed it over $184,000 for blades sold and delivered to Eastman from October 2008 through January 2009. Eastman's answer to the complaint did not deny that it ordered and accepted the blades. Instead, its answer included a counterclaim for judicial dissolution under BCL Section 1104-a contending that James Woods had engaged in oppressive conduct and breach of fiduciary duty to Eastman as minority shareholder, and that James Woods' lack of cooperation threatened the viability of Woods Knife and consequently Eastman's 49% interest.

Woods Knife then moved for summary judgment on its claim for goods sold and delivered. In opposition, Eastman contended that Woods Knife was "moribund," "insolvent" and "in de facto dissolution" due to the cessation of Eastman's orders. Eastman also suggested that any monies recovered by Woods Knife in the action "will not go to support the business, but will instead go to the individual [James Woods], to the detriment of Eastman's interest." Eastman offered to pay $100,000 into court to retire "legitimate debts" of Woods Knife, "pending an accounting to determine all of the plaintiff's legal liabilities and who should receive payment."

Justice Palmieri granted summary judgment for Woods Knife based on the admissions in Eastman's answer and opposing affidavit that it had accepted shipment of the blades, that the amounts sought were accurate, and that Woods Knife had not been paid. Eastman's opposition, based on the alleged need to dissolve Woods Knife, was no defense, Justice Palmieri wrote, because

even if dissolution of the plaintiff is available to the defendant as 49% shareholder, this cannot serve as a reason to deny plaintiff judgment on its first and second causes of action. The Court agrees with the plaintiff that the defendant's concern about how payment will be used by the plaintiff is irrelevant in the context of the present action.

Woods Knife also sought summary judgment on the merits dismissing Eastman's dissolution counterclaims, which Justice Palmieri denied. He did, however, dismiss them without prejudice as procedurally defective, for failure to comply with BCL Section 1106's above-noted requirements for the commencement of a judicial dissolution proceeding.

Eastman appears to have heeded Justice Palmieri's advice. On October 8, 2009, Eastman filed a separate new proceeding in Nassau County Supreme Court which, from the limited information available online, appears to be one for judicial dissolution of Woods Knife. If there's any decision in the new case, I'll be sure to report on it.

"Unclean Hands" Defense Can Backfire in Deadlock Dissolution Case

Peter A. Mahler — Mon, 12 Oct 2009 06:00:00 -0500

The seminal New York case defining "oppressive" conduct under the statute authorizing a minority shareholder to seek corporate dissolution, Matter of Kemp & Beatley, Inc., 64 NY2d 63, 74 (1984), cautioned that a minority shareholder "whose own acts, made in bad faith and undertaken with a view toward forcing an involuntary dissolution, give rise to the complained-of oppression should be given no quarter in the statutory protection." This language gave birth to what has become known as the "unclean hands" defense in shareholder oppression cases under Section 1104-a of the Business Corporation Law (BCL). The unclean hands defense often is based on allegations that the petitioning minority shareholder secretly is involved with or planning to launch a competing business to steal the customers and good will of the company whose dissolution is sought.

Over the years since Kemp, the unclean hands defense also has crept into dissolution cases brought by a 50% shareholder under BCL Section 1104 based on deadlock and internal dissension. Unlike oppression cases under Section 1104-a, where the minority shareholder must prove some form of at-fault or unfair conduct by the majority, cases under Section 1104 focus on the deterioration of the relationship between the two 50/50 shareholders and the resulting corporate paralysis, without necessarily assigning fault to one side or the other.

A recent decision by Nassau County Commercial Division Justice Stephen A. Bucaria, in Matter of Rieger (Airmarine Electroplating Corp.), Short Form Order, Index No. 010524/09 (Sup Ct Nassau County Aug. 27, 2009), illustrates the difficulty of maintaining the unclean hands defense in a deadlock dissolution case where, absent compelling proof, the allegations of inequitable conduct by the petitioner can themselves contribute to the court's sense of shareholder hostility and corporate dysfunction warranting dissolution.

Rieger involved a fight between brother and sister Ernest and Laurie Rieger. The Riegers are 50/50 shareholders of Airmarine Electroplating Corp. which is in the business of refurbishing airplane parts. The Riegers also co-own a second company called Airlift Hydraulics which holds the FAA certificate enabling Airmarine to receive FAA aircraft component refurbishing manuals.

Ernest filed a petition for judicial dissolution of Airmarine under Section 1104 based on animosity and dissension between himself and his sister. He alleged that they could not reach agreement on how to manage the corporation; that the ensuing deadlock prevents the corporation from benefiting the shareholders; and that no purpose would be served by holding a shareholders or directors meeting.

Laurie sought dismissal of the petition based on Ernest's "unclean hands". As described in Justice Bucaria's decision, Laurie claimed that Ernest was seeking to dissolve Airmarine

to create his own personal corporation using the same clients and the same FAA certificate that are used by [Airmarine]. Laurie alleges that her theory is bolstered by the fact that Ernest does not seek to dissolve Airlift Hydraulics, because then he would no longer be in possession of the FAA certificate and would not be able to open his own personal Aircraft refurbishing corporation.

Laurie also alleged that her brother was misappropriating corporate funds, taking excessive salary, and "hiding" documents from her.

The court's reference to Laurie's "theory" may or may not indicate a lack of hard proof of her brother's plans to start his own refurbishing business. In any event, Justice Bucaria held that her unclean hands defense was not adequate to stave off dissolution since "'the critical consideration is the fact that dissension exists and has resulted in a deadlock precluding the successful and profitable conduct of the corporation's affairs'" (quoting Matter of Goodman v. Lovett (200 AD2d 670)). Laurie's allegations of misconduct by her brother, Justice Bucaria wrote,

essentially demonstrate that the standard for involuntary dissolution has been met. Laurie and Ernest clearly do not agree on how the Corporation should be run, and act in a hostile manner towards one another. Laurie further admits that the company has not been operating at a profit as of late, and she has provided no plan that the company will do so in the future. Laurie states that Ernest has breached his good faith duty to her as a co-shareholder, and this only re-iterates that the standard for involuntary dissolution has been met.

The fact that Laurie claims Ernest acted in bad faith regarding the management of the Corporations is of no moment, inasmuch as the dissension and distrust is palpable and real. The petitioner showed, and the respondent reinforced, that the disagreements between the two parties "pose an irreconcilable barrier to the continued functioning and prosperity of the corporation." [Citations omitted.]

It would be an overstatement to say that the unclean hands defense has no application in the deadlock dissolution context. I can readily imagine a scenario in which a 50% shareholder deliberately manufactures dissension and brings a dissolution proceeding in furtherance of a plan to walk off with the company's customers. It really boils down to a matter of proof and, as Rieger illustrates, in the absence of compelling proof the allegations of unclean hands only serve to reinforce the atmosphere of irreconcilable hostility supporting involuntary dissolution.