Welcome to the 12th annual edition of Summer Shorts. This year’s edition features brief commentary on a handful of recent decisions by New York trial judges and appellate courts in a variety of business divorce cases involving capital calls, recapitalization, dissolution agreements, derivative vs. direct claims, and judicial dissolution. Click on the case names to read the decisions.
“Grammatical Irregularities” Don’t Govern Operating Agreement’s Capital Call Provision
Chen v 697 Dekalb LLC, 2022 NY Slip Op 32418(U) [Sup Ct Kings County July 18, 2022]. Does an operating agreement’s provision stating that “additional capital contribution may be made at such time and in such amounts as the Members shall determine” require unanimous consent of the LLC’s members, or does majority consent suffice? Brooklyn Commercial Division Justice Leon Ruchelsman found that this and other “grammatical irregularities” in the agreement concerning member consent to assignment and the admission of new members “do not govern the plain meaning of the agreement” in this suit brought by a 25% member seeking judicial dissolution of a realty-holding LLC after the majority members threatened dilution unless he contributed an additional $485,000 on top of his original $300,000 investment.
The decision denies both the defendant majority members’ motion to dismiss the complaint and the plaintiff’s motion for summary judgment granting judicial dissolution, finding a “fundamental disagreement between the parties” precluding a summary determination “whether the initial contribution made by the plaintiff was intended to be the only contribution he needed to make or whether others were necessarily contemplated,” as well as “whether the company maintains the necessary finances to continue and whether it remains viable.”
Oddly, neither the parties’ briefs nor the decision mentions the governing Amended Operating Agreement’s omission of any provision authorizing dilution or other consequences for a member’s failure to make an additional capital contribution, as required by LLC Law § 502(c). The omission arguably takes on even greater weight in view of the capital call provision in the LLC’s original operating agreement, to which the plaintiff is not a signatory, authorizing the managers to make capital calls and allowing contributing members to make up a non-contributing member’s shortfall, thereby triggering adjustment of the members’ percentage ownership interests.
Majority Shareholders’ Recapitalization Violated Unanimous-Consent Requirement in Shareholders Agreement
Unlike the Chen case, in Salansky v Empric, 2022 NY Slip Op 04844 [App Div 4th Dept Aug. 4, 2022], there was no ambiguity in Section 4 of the shareholders agreement explicitly requiring unanimous shareholder consent to any amendment of the corporation’s certificate of incorporation, which originally authorized 200 capital shares of which 100 were issued. At inception, the plaintiff held 45% of the issued capital shares and the two defendants held 45% and 10%. Came a time when the defendants filed an amended certificate without plaintiff’s consent increasing the corporation’s authorized shares from 200 to 2,000, and concurrently issued to themselves additional shares in consideration of a $500,000 capital contribution, all of which had the effect of diluting the plaintiff from 45% to less than 3%.
The lower court granted the defendants’ summary judgment motion dismissing plaintiff’s causes of action contesting the recapitalization and stock issuance. On appeal by plaintiff, the Appellate Division, Fourth Department, reversed that part of the lower court’s order and granted summary judgment of liability in plaintiff’s favor. Citing the unambiguous language of Section 4, the appellate panel squarely ruled that “plaintiff established that defendants violated the shareholder agreement by amending the [certificate of incorporation] without his written approval.”
Interestingly, the defendants argued their actions were authorized by the corporation’s by-laws and that Section 4 conflicts with Business Corporation Law § 803(a) providing that a certificate of incorporation can be amended by majority vote unless the certificate itself requires a greater vote, which the subject corporation’s certificate did not. The appellate panel saw no conflict, pointing out that the plaintiff’s claim was based on a violation of the shareholders agreement by amending the certificate without his approval, and that § 803(a) “does not prohibit parties from entering into a separate agreement that requires unanimity among the shareholders to amend a certificate of incorporation.”
Dissolution Agreement Did Not Exclude Good Will; Court Grants “Mohawk” Injunction
In Ng v Ng, 2022 NY Slip Op 31750(U) [Sup Ct NY County May 27, 2022], two brothers agreed to divide up the many businesses they jointly owned pursuant to a Dissolution Agreement whose express terms provided for the plaintiff’s acquisition of “the entire interest of [the defendant brother]” in each of the companies listed in a certain schedule to the agreement “with all property rights owned by [defendant] therein” including “all associated assets and liabilities.” One of the companies acquired by plaintiff, called Golden Fortune, was the longtime, exclusive eastern U.S. distributor for a certain supplier of a Chinese bakery product known as mooncakes. Plaintiff sued his brother for violation of the Dissolution Agreement and sought preliminary injunctive relief based on allegations that his brother had formed a competing company and was soliciting Golden Fortune’s customers, employees, and suppliers including its mooncakes supplier.
The defendant brother opposed the requested injunction, as summarized by Manhattan Commercial Division Justice Andrew Borrok in his decision granting the injunction, on the ground that defendant “merely transferred his stock or membership interests and that he somehow retained interests in the company’s good will.” Not so, ruled Justice Borrok, finding that defendant’s contention “is belied by both the express language of the Dissolution Agreement and its intent as part of the complete business divorce that the Dissolution Agreement effectuated.”
The root of the problem in Ng, and contrary to what one would expect in an agreement dividing up jointly owned businesses, was that the Dissolution Agreement had no express restrictive covenants. The absence of covenants explains the parties’ focus on good will and Justice Borrok’s reliance on the Court of Appeals’ 1981 opinion in Mohawk Maintenance Co. v Kessler holding, on the one hand, that the seller of a company including its good will has an implied duty not to engage in solicitation impairing the company’s good will and, on the other hand, the seller has no general non-compete duty absent express agreement. Justice Borrok accordingly limited the grant of preliminary injunctive relief to the one supplier of mooncakes with which Golden Fortune had an exclusive, lucrative business relationship for over 20 years.
Court Delivers Tough Lesson in Pleading Derivative vs. Direct Claims
In a post earlier this year, I wrote that motions to dismiss a dissident owner’s direct claims that should have been brought derivatively, or derivative claims that should have been brought directly, are among the most common skirmishes over the adequacy of pleadings at the outset of business divorce litigation. Mohinani v Charney, 2022 NY Slip Op 04782 [App Div 1st Dept Aug. 2, 2022], is the rare case in which, after discovery and after trial, the lower court dismissed the LLC members’ lawsuit pleading direct claims on the ground that all the damages plaintiffs sought to prove and recover upon a theory of defendant’s breach of fiduciary duty would have been losses directly suffered by the LLC.
In its decision earlier this month rejecting the plaintiff’s appeal, the Appellate Division, First Department, highlighted two of the plaintiff’s losing arguments. First, in response to plaintiffs’ argument that their status as the only other members of the LLC obviated the requirement that a claim of misappropriation of funds owed to the LLC be brought derivatively, the court answered simply that “[a]ny injury is to [the LLC], and any damages must be recovered by [the LLC],” citing as authority the Court of Appeals’ 1989 opinion in Glenn v Hoteltron Systems, Inc.
Second, responding to plaintiffs’ argument that the defendant waived any defense based on the derivative nature of the claims because he did not assert lack of standing in his answer or by a pre-answer motion to dismiss, the court turned the table on plaintiffs’ waiver argument, writing:
Throughout this decade-long litigation, through their posttrial submissions, plaintiffs consistently asserted these causes of action as direct claims on their own behalf, not as derivative or double-derivative claims. It is only now, upon appeal, after the trial court has dismissed the claims for lack of the element of an injury directly suffered by plaintiffs, that plaintiffs argue that they should be permitted to pursue the claims as derivative or double-derivative claims, and to amend their complaint accordingly. Indeed, when the court and defense counsel sought clarification of the nature of plaintiffs’ claims in the months preceding trial, plaintiffs never moved to amend the complaint to plead derivative claims and argued only that [defendant’s] duties to plaintiffs, rather than to LHC, were breached. Plaintiffs never sought leave to replead their claims as derivative claims and thus waived their argument that they should be able to do so now.
As noted above, the issue of direct vs. derivative is almost always raised early in the case on a pre-answer dismissal motion for lack of standing, which then usually allows the plaintiff to amend the complaint if the court rules that a derivative claim should be pleaded directly or vice versa. Mohinani teaches that the risk of getting it wrong exists even if the defendant doesn’t raise the issue until late in the game.
Court Denies Dissolution Petition Involving Relocation of Business Out of Affiliated LLC’s Building
Longtime readers of this blog may recall my multiple posts about the Mace v Tunick case in which a minority member of an LLC sought judicial dissolution after the controlling shareholders of the affiliated corporation that occupied the building owned by the LLC relocated out-of-state, leaving the LLC vacant and with no rental income. The fact pattern in Matter of Garcia [People’s Accident Information Service, Inc.], 2022 NY Slip Op 31261(U) [Sup Ct NY County Mar. 28, 2022], presents the reverse scenario in which a minority shareholder petitioned to dissolve the operating business after the majority shareholder moved the business office out of the building co-owned by the same parties. In both cases, the dissolution petitions went down to defeat, albeit for different reasons.
The parties in Garcia own and operate a business incorporated in 1997 to provide guard and security services under annual contracts to a relatively modest number of corporate clients. In 2009, the owners formed a separate LLC to purchase a building to house the security guard business. In 2021, the petitioning 49% shareholders filed under Business Corporation Law § 1104-a to dissolve the security guard business, alleging a variety of oppressive conduct by the 51% shareholder amounting to a squeeze-out. The petitioners also sought a preliminary injunction preventing the majority shareholder from proceeding with her plan to move the corporation’s office out of the LLC’s building to another building owned by an unrelated third party.
The petitioners contended that the security business and the LLC’s building were essentially two parts of the same overall business, and the proposed new location was highly undesirable. The respondent majority shareholder countered that the new location offered far better public transportation access to current and potential employees who are overwhelmingly hourly-paid security guards, and that the petitioners’ opposition to the move was motivated by their reliance on the operating business to continuing to pay rent and other building expenses rather than the LLC members having to pay out of their own pockets.
The court’s decision unfortunately offers no analysis of its decision dismissing the petition, merely parroting the language of BCL § 1104-a in stating its determination that the petitioners failed to show that the respondent had engaged in illegal, fraudulent or oppressive actions or that the property or assets of the corporation are being looted, wasted, or diverted for non-corporate purposes. The case nonetheless offers an unspoken lesson for any minority owner of a business that occupies and pays the carrying costs of business premises with the same ownership, to secure a voice in any decision to relocate the business or perhaps to require a sale of the property if it cannot timely be relet.