Occasionally, we come across court cases in which the majority owners so egregiously mistreated their minority co-owners that it’s difficult not to write about it — if only as a lesson in what not to do to separate oneself as co-owners.

There are, of course, many ways close business co-owners can legally separate co-owners. A negotiated, voluntary buyout is one option. If permitted under the entity’s governing statutes and contracts, if any, a cash-out merger is another option. A third option is litigation wherein the petitioner, or respondent, may request a compelled or equitable buyout of one side’s interest by the other.

But what one should never do, lest face some potentially harsh legal consequences, is secretly transfer the entity’s assets to another, strip the original entity of any value, and leave the minority owner holding an empty bag with no money for his or her converted equity.

Former Manhattan Commercial Division Justice Shirley Werner Kornreich encountered this fact pattern in a decision we wrote about five years ago, Stavroulakis v Pelakanos, 58 Misc 1221(A) [Sup Ct, NY County 2018]).

In Stavroulakis, the majority owners of a corporation that owned the “Bareburger” chain of restaurants transferred all of the business’s assets to a new entity in which the minority owner, who was abroad at the time, lacked any interest, leaving the transferring entity “an empty shell.” Things went poorly for the majority owners in that case, Justice Kornreich granting the defrauded minority owner summary judgment on liability on several claims.

The facts of a recent decision, Ng v Asquared Group, Inc., ___ AD3d ___, 2023 NY Slip Op 04598 [2d Dept Sept. 13, 2023]), are eerily similar, and in several respects much worse, than those Justice Kornreich excoriated in Stavroulakis.

The Sushi Business and its Owners

In 2004, four restaurant entrepreneurs, including the plaintiff’s son, Choi, entered into a New York general partnership to form one or more Japanese restaurants in Queens now named “Mira Sushi,” its partnership agreement scribbled onto a generic Bender’s form.

Later, the parties, including the plaintiff, Ng (to whom Choi transferred his interest because he was in Asia on other business), reorganized the partnership as two corporations, Kyoto Restaurant, Inc. and Kyoto Dining Group, Inc. (together “Kyoto”), governed by identical shareholders agreements providing that Ng owned 25% and Lee 75% of the business.

Discovery of the Scheme

Around 2010, Lee opened and successfully operated the restaurants, providing Ng certain distributions on equity and financial statements. But in January 2015, both abruptly ceased.

Ng later learned:

  • Long prior, in April 2013, Lee formed a new corporation called Asquared Group, Inc. (“Asquared”), to which Lee transferred all of Kyoto’s assets. Asquared then assumed operation of Kyoto’s restaurants;
  • In January and February 2014, Lee formally dissolved the two Kyoto entities with the New York Department of State; and
  • In October 2016, Lee “sold” Asquared to Stellar 153, Inc. (“Stellar 153”), an entity owned by his father’s girlfriend, almost all the consideration for which was deferred payments under a zero-interest promissory note.

Her investment in the business allegedly stolen, Ng filed a complaint alleging breach of fiduciary duty, waste, conversion, unjust enrichment, constructive trust, an injunction against Lee managing the businesses, and an accounting. Multiple claims sought punitive damages.

I can’t say how many business divorce complaints I’ve seen with punitive damage demands. The number is large. But I can say how many I have seen succeed. Not one. But this case was different.

The Default Judgment

For more than a year after being served, Lee and his co-defendants declined to answer or move to dismiss the complaint, finally forcing Ng to move for a default judgment.

Lee opposed default on the grounds that he was “actively attempting to settle” with Ng, and “was awaiting the final decision” in another litigation which, according to Lee, “would affect the final settlement between the parties.”

Queens County Supreme Court Justice Denis J. Butler ruled that Lee and his co-defendants failed to demonstrate either a meritorious defense or a reasonable excuse for their default. The court ruled that “all Defendants are held to be in default, and an inquest shall be held on the issue of damages.”

The entry of a default judgment against Lee might have been an opportune time for Lee to cut losses and approach Ng about settlement. “By defaulting, the defendant[s] admitted all traversable allegations in the complaint, including the basic allegation of liability,” leaving only damages remaining (Abad v 2431 Francis Lewis, LLC, 219 AD3d 1389 [2d Dept 2023] [quotations omitted]).

But Lee chose to roll the dice at a damages inquest facing the prospect of compensatory damages, punitive damages, and an award of attorneys’ fees under Section 24 of the shareholders agreements providing that “should it be necessary to retain and utilize counsel to enforce this Agreement, the prevailing party shall be entitled to all costs incurred including legal expenses incurred, appellate fees and all costs.”

The Damages Inquest and Money Judgment

The damages inquest was a bloodbath.

Hon. Salvatore J. Modica (before whom I also did a successful, post-default damages inquest), issued a lengthy post-trial decision in which the court:

  • Resolved all credibility determinations in favor of Ng and against Lee;
  • Held that Ng correctly brought her claims directly, rather than derivatively, because Lee perpetrated “a scheme to freeze her out of her ownership interest in [Kyoto] without any compensation,” in which Lee “intended to and did, in fact, steal from the plaintiff”;
  • Applied the valuation formula in Section 10 of the shareholders agreements, concluding that the value of the equity Lee took from Ng was $135,208.98, awarding this amount as compensatory damages;
  • Rejected any contention that Lee was entitled to be indemnified for other lawsuits against him under the shareholders agreements as an offset against damages, ruling that his egregious conduct “amounts to a waiver of such rights that may exist under the contracts”;
  • Held that Ng provided by “clear and convincing evidence” Lee’s “spite, malice or evil motive, sufficient to warrant an award of punitive damages,” describing Lee’s conduct as “surreptitious and devious” behavior, “deceptiveness and deceit,” an “outright fraud,” and a “theft,” awarding Ng $700,000 in punitive damages;
  • Awarded Ng attorneys’ fees, costs, and disbursements of $42,345; and
  • Awarded Ng pre-judgment interest at 9% on all of the foregoing amounts.

The final judgment, from which Lee appealed, totaled nearly $1 million.

The Appeal and its Outcome

On appeal, Lee challenged both the motion court’s entry of a default judgment and the inquest court’s imposition of compensatory and punitive damages. You can read the parties’ briefs here, here, and here.

The appeals court rejected each and every one of Lee’s appellate challenges but one, holding:

  • The existence of “purported settlement negotiations” do “not constitute a reasonable excuse for failing to appear or answer the complaint”;
  •  Compensatory damages do not require “mathematical certainty but reasonable certainty,” and the “calculations provided by plaintiff” upon which the inquest court based its damages award were “not the result of speculation, conjecture, or imagination”; and
  • “Contrary to Lee’s contention, the record supports the Supreme Court’s determination, in effect, that Lee wrongfully diverted corporate assets for the purpose of usurping the plaintiff’s ownership interest in the Kyoto corporations and that this constituted willful, wanton, or reckless misconduct sufficient to support an award of punitive damages.”

The only aspect of the lower court rulings with which the appeals court disagreed was the amount of punitive damages, writing that “under the circumstances of this case, the award of punitive damages was excessive,” modifying the judgment to reduce the punitive damages award from $700,000 to $300,000.

Punitive Damages and Due Process

Though it did not say so explicitly, the appeals court suggested the punitive damages award violated the Due Process Clause of the Fourteenth Amendment of the United States Constitution, citing two cases, citing State Farm Mut. Auto. Ins. Co. v Campbell (538 US 408 [2003]), and Gomez v Cabatic (159 AD3d 62 [2d Dept 2018]).

In both cases, the courts applied the following three-part test to determine whether punitive damages are unconstitutional:

(1) the degree of reprehensibility of the defendant’s misconduct; (2) the disparity between the actual or potential harm suffered by the plaintiff and the punitive damages award; and (3) the difference between the punitive damages awarded by the jury and the civil penalties authorized or imposed in comparable cases.

In both cases, the courts wrote that “few awards exceeding a single-digit ratio between punitive and compensatory damages . . . will satisfy due process.” In Ng, before modification, the punitive damage award had a roughly 5-to-1 ratio. After modification, it had a roughly 2-to-1 ratio. A disappointing modification for the plaintiff, no doubt, but a hefty punitive damages award nonetheless.

The bottom line: if you are sued in a lawsuit, never ever ignore the complaint. And if you are the majority owner of a business thinking of separating from a minority owner, never ever just take the business interest for yourself. Attempt a negotiated buyout. Look into whether a cash-out merger is an option. If neither are possible, pursue a litigated resolution. Don’t, repeat, don’t, use self-help and take the interest for yourself. The punishment for doing so can be exceptionally harsh.