In the menagerie of closely held companies, those owned and controlled by 50/50 business partners pose unique benefits and challenges.
On the benefit side, co-equal ownership and control can foster cooperation, consensus, and synergy of complementary expertise by virtue of co-dependency and neither owner having the upper hand. It can also foster deep and abiding personal relationships of trust, mutual respect, tolerance, and friendship that contribute to business success. Unus pro omnibus, omnes pro uno.
On the challenge side, well, if you’re a regular reader of this blog, you already know the parade of horribles that can befall the 50/50 company when over time the co-owners develop divergent financial or other interests and/or fundamental disagreements creating irreconcilable deadlock over business operations, strategic goals, finances, productivity, personal commitment, succession planning and, of course, money, money, money.
When one 50% owner makes the fateful decision to sue the other, claiming the other has breached contractual or fiduciary duties owed the company and causing it harm, there’s always the temptation to file suit in the company’s name rather than bringing a shareholder derivative action, for two reasons.
First, there’s the belief (justifiable or not) that putting on the corporate mantle dispels the court’s perception that it’s merely a fight for control between two shareholders and thereby puts the plaintiff acting for the good of the company on higher ground.
Second, assuming a 50% owner seeking to commence litigation has the power of the checkbook, suing in the company name means the company hires and pays the lawyer from the company kitty instead of having to finance a derivative lawsuit from the shareholder’s own pocket. That also means the defendant 50% owner indirectly subsidizes the lawsuit against him, her, or itself as well as paying their own legal fees. Talk about settlement leverage.
The Battle Between Newsweek’s 50/50 Owners
We’ll never know if either or both of those reasons were at play in NW Media Holdings Corp. v IBT Media Inc., in which the Manhattan-based Appellate Division, First Department, last month affirmed a lower court’s ruling dismissing a lawsuit brought in the name of the company that in 2018 acquired a 50% interest in the digital weekly news magazine Newsweek.
The plaintiff company, NW Media, is co-owned 50/50 by former friends Dev Pragad and Jonathan Davis, both of whom also constitute NW Media’s Board of Directors. Mr. Davis also owns the defendant company, IBT Media, which sold Newsweek to NW Media in 2018 structured as a Membership Interest Purchase Agreement. In 2022, Mr. Pragad caused suit to be brought in NW Media’s name against IBT alleging breach of IBT’s indemnification obligations under the 2018 purchase agreement.
The parties quickly locked horns on the threshold issue whether Mr. Pragad, as President of NW Media, possessed authority to bring suit against IBT in the name and right of NW Media when,
- before filing the suit, Mr. Pragad showed Mr. Davis a draft of the complaint, to which Mr. Davis strenuously opposed its filing;
- the company’s by-laws provide that “the business of the Corporation shall be managed by its Board of Directors”;
- the by-laws, while providing that the President “shall have responsibility for the general management and control of the business and affairs of the Corporation” and “shall perform all duties and have all powers which are commonly incident to the office of chief executive,” do not expressly authorize the President to commence litigation without Board approval; and
- Mr. Pragad ignored Mr. Davis’s request for a Board meeting to address the issue.
The Lower Court Sides with IBT
Ruling last December on IBT’s motion to dismiss, Manhattan Commercial Division Justice Melissa A. Crane more than rose to the occasion. Her scholarly decision carefully analyzed Mr. Pragad’s legal authority to file the suit, which she described as “legally fascinating because there appear to be two distinct lines of cases that lead to opposite results.”
Justice Crane identified the competing, foundational cases as the Court of Appeals’ 1949 opinion in Sterling Industries Inc. v Ball Bearing Pen Corp. and its 1958 opinion in Paloma Frocks, Inc. v Shamokin Sportwear Corp.
In Sterling, before the president of the plaintiff company commenced litigation, its four-member board, two of whom were representatives of the defendant company, deadlocked on the question whether to sue the defendant company for breach of contract. As Justice Crane summarized,
The Court of Appeals held that, where the by-laws of the corporation did not refer to the right of the president to commence litigation, but instead provided that the act of a majority of the board should constitute the act of the board, the authority of the president to commence litigation terminated “when a majority of the board of directors at the special meeting refused to sanction it.”
“Cases following Sterling,” she continued, including Crane, A.G. v 206 West 41st Street Hotel Assoc. LP (1st Dept 2011), Stone v Frederick (3d Dept 1997), and Giaimo v EGA Associates (1st Dept 2009),
cement the concept that, where the by-laws do not overtly give the president the right to commence litigation, and there is board or shareholder deadlock about the propriety of doing so, the president then lacks the authority to bring an action directly in the name of the corporation.
Notice that in her description of Sterling‘s holding, Justice Crane used the phrase, “the authority of the president to commence litigation terminated,” which begs the question of what authority existed prior to its termination.
Enter Paloma Frocks, which Justice Crane assessed as having “seemingly cut back on Sterling‘s holding” by recognizing, even without explicit by-laws authorization, a corporation president’s “presumptive authority” to commence legal proceedings in the company’s name against an insider or entity whose ownership has co-equal voting control of the plaintiff company, absent a negative board vote, or some other indicia of board disapproval or deadlock, or a course of conduct over an extended period of time in which the president freely exercised such authority.
Justice Crane construed as supportive of Paloma‘s “cut back on Sterling‘s holding” another Court of Appeals opinion handed down one year after Paloma, in West View Hills Inc. v Lizau Realty Corp. In that case, the court upheld the plaintiff corporation’s authority to bring suit in the company’s name against another company with identical directors and officers. As Justice Crane wrote,
In allowing the suit, the Court of Appeals distinguished West View Hills from “the classic case requiring resort to a stockholder’s derivative action to protect minority interests.” The Court distinguished Sterling by the fact that the West Hill board had taken no action, while the Sterling board refused to sanction the president’s authority to bring the suit. [Jump cites omitted.]
Based on her analysis of the “two distinct lines of cases that lead to opposite results,” Justice Crane concluded that the Newsweek case “fits squarely into Sterling” based on (1) the absence of any by-laws provision expressly authorizing the president to commence litigation, (2) the by-laws provision stating “the business of the corporation shall be managed by its board of directors,” (3) the by-laws provision requiring a shareholder vote in the event of board deadlock, and (4) because it was undisputed that, although there was no formal vote, not only did Davis withhold consent,
he expressed extreme disapprobation to the filing of this lawsuit. Thus, the board was deadlocked, there being only two members. Accordingly, under Sterling and its progeny, as the president of a closely held corporation, Pragad lacked the authority to act unilaterally against Davis’ interest.
* * * * * * * *
. . . Although IBT may have a separate duty to NW Media, the fact remains Davis controls IBT and Davis has objected to the institution of the suit. This leaves plaintiff, who is essentially Dev Pragad, recourse through a derivative suit only.
NW Media Loses on Appeal
Last month’s relatively brief decision by the Appellate Division rejecting NW Media’s appeal essentially adopted Justice Crane’s analysis and conclusion that case dismissal was required by Sterling. Here’s what it said:
The motion court correctly granted IBT’s motion to dismiss the complaint. Here, as was the case in Sterling Indus. v Ball Bearing Pen Corp. (298 NY 483 ), Pragad lost his presumptive authority to initiate this action in the corporation’s name because NW Media’s board was deadlocked. Control of NW Media’s board is split equally between Pragad and Davis. As in Sterling, NW Media’s by-laws provide that “the business of the Corporation shall be managed by its Board of Directors,” and that “the vote of a majority of the Directors present at the time of the vote . . . shall be the act of the Board of Directors.” Plaintiffs do not dispute that Davis, through counsel, expressly objected to the filing of the complaint, which left the board deadlocked. Thus, any actual or implied authority Pragad may have had to commence this action was “terminated when a majority of the board . . . refused to sanction it” (Sterling, 298 NY at 489; see also Crane, A.G. v 206 W. 41st St. Hotel Assoc., L.P., 87 AD3d 174, 176 [1st Dept 2011]). Even without a formal board meeting, which Davis requested, to no avail, his affirmative written objection constituted a “direct prohibition by the board” sufficient to constitute a deadlock (Rothman & Schneider v Beckerman, 2 NY2d 493, 497 ).
The court also rejected NW Media’s reliance on Paloma, in which the president’s controverted action was commencement of arbitration, insofar as the Court of Appeals found that the directors had authorized the president to sign the contract containing the arbitration clause. NW Media argued that the indemnification provision in its purchase agreement with IBT likewise authorized Mr. Pragad’s commencement of suit against IBT. Here’s how the First Department distinguished Paloma:
That logic, however, does not apply to Pragad’s attempted enforcement, through litigation without board approval, of the indemnification clause. Paloma was objecting to something to which it had already consented in the parties’ contract: resolving disputes through arbitration. Here, IBT’s agreement to the purchase agreement, through Davis, may have included an agreement to indemnify NW Media under certain conditions, but it did not constitute a broad agreement to Pragad’s initiation of litigation against IBT on behalf of NW Media absent board approval. By taking that action, Pragad was not “merely carrying out an existing agreement” constituting “a routine step in the performance” of the contract, as was the case in Paloma (id.).
The Parties Quickly Settle
A mere two weeks after the First Department’s affirmance, NW Media and IBT filed with the lower court a joint motion to discontinue all litigation between the parties, including NW Media’s direct action against IBT as well as a pair of dueling derivative actions brought by Messrs. Pragad and Davis. The motion, which is pending as of this writing, stated that the parties “have reached a confidential settlement agreement that resolves all ongoing litigation between them.” Read here Newsweek’s coverage of the settlement.
A Hole in the Indemnification Agreement?
From what I’ve read, at the time it entered into the Membership Interest Purchase Agreement with IBT, NW Media had good reason to be concerned about a potential slew of liabilities arising from IBT’s prior control of Newsweek.
The Purchase Agreement accordingly included a provision requiring IBT to indemnify NW Media, among other things, for all losses, damages, etc., arising from IBT’s “ownership” and “management” of the company “prior to the Closing.”
The Purchase Agreement between sophisticated parties involving a highly valuable asset presumably was negotiated and drafted by sophisticated counsel. One has to wonder, given the post-closing, 50/50 ownership and representation on the board, why it was not plainly foreseeable that Mr. Davis, having equal control of NW Media’s board, would object to commencement of suit by NW Media against his other company, IBT, to compel indemnification. It’s a mystery why NW Media did not insist on and obtain language giving it authority to commence an indemnification action with or without board consent.
For those who want to take a deeper dive, I have two recommendations.
First, over a decade ago I blogged here, here, and here about Hellman v Hellman. The case was an extended litigation brawl between 50/50 shareholders/brothers over the authority of one brother as president to enter into a new lease relocating the business over the other brother’s objection without getting pre-approval by the company’s board consisting of the two brothers. While not involving authority to commence litigation, the opinions of the lower and appellate courts ultimately supporting the president’s leasing authority focused largely on the interplay between, on the one hand, the president’s presumptive authority acknowledged in Paloma and its progeny and, on the other hand, board supremacy as acknowledged in Sterling and its progeny.