The Dissatisfied Minority Shareholder or LLC Member: What Can She Do After the Bloom Is Off the Rose

Publication Source: New York Law Journal

Maybe you have had the same experience. A new client comes to you with a story. She had significant disposable funds, so she did what everyone does—she invested in the “next big thing.” She was so excited that she did not even consult with a lawyer because she was afraid to lose this “once in a lifetime opportunity.” The client invested $500,000 for what she was told was initially a 20 percent interest in the venture, which would increase to 50 percent after two years pursuant to an oral agreement. She was also told she would begin making money immediately. Not surprisingly, two years come and go and she has not received a single distribution, and all of her requests for relevant information regarding the company’s finances have been ignored. When the venture began, optimism was through the roof and dreams of a pain-free retirement danced in her head. But, alas, things did not turn out to be what the client had hoped. So, you first determine what form the business was in, i.e., whether she invested in a business corporation or a Limited Liability Company. Then you look for the underlying agreements and you are told “I don’t have any” and off you go. The fact is, minority shareholders/owners have very little (or potentially no) control over when and how much money they will receive in distributions based on their investment (if any). So, after gently admonishing your client that she should have come to you or your corporate group before she made such an investment, you ascertain what legally supportable angle may be available to get your client out.

Rights Under the BCL

You learn your client invested in a business corporation. Under the BCL, a minority shareholder’s rights are limited. You may start by demanding to inspect the books and records under BCL §624(a). Under that section, any person who is a shareholder of record of a corporation is entitled to examine the minutes of the proceedings. There probably are no minutes. Under BCL §624(e), you can request an annual balance sheet and profit and loss statement for the preceding fiscal year. You may also request an interim balance sheet or profit and loss statement that has been distributed to its shareholders or otherwise made available to the public. If any of this is available and, indeed, is given to you, it will not tell you much. Dissolution is then discussed; however, initially, your client states she does not want to see the business liquidated as she still has great hopes for its future. As such, you inquire as to what she knows about how the business is being managed. Maybe she has information pertaining to her fellow shareholder’s misuse of corporate funds, potentially supporting a suit based on breach of fiduciary duty. But first, under BCL §626(c), your client must explain what efforts she made to inform the company’s board of what she knew and that she sought board action, which must be pled in the complaint “with particularity.” Her failure to do so is not per se fatal, as she can commence a suit and plead the reasons why such a request would be futile. Cement Masons Local 780 Pension Fund v. Schleifer, 56 Misc.3d 1204(A) (Sup. Ct., N.Y. Cty., 2017). To withstand a motion to dismiss based on failure to adequately plead futility, a complaint needs to allege “with particularity that (1) a majority of directors are interested in the transaction; or (2) the directors failed to inform themselves to a degree reasonably necessary about the transaction; or (3) the directors failed to exercise their business judgment in approving the transaction.” Id. at 4 quoting Marx v. Akers, 88 N.Y.2d 189, 198 (1996). This will not be an easy road. First, your client must understand this will be a derivative suit, not on her own behalf but on behalf of the corporation. It is unlikely money will come to her directly. However, your client’s attorney fees may be recoverable. See McKinney’s BCL §626(e). Also, keep in mind that the allegations of breach of fiduciary duty must be pled with particularity as required by CPLR 3016(b). Next, there are numerous defenses to certain corporate actions. If she is claiming that her fellow shareholder took excessive compensation, there is a potential defense under BCL §713(e), which states that “[u]nless otherwise provided in the certificate of incorporation or the by-laws, the board shall have authority to fix the compensation of directors for services in any capacity.” Then you must contend with the business judgment rule which “bars judicial inquiry into actions of corporate directors taken in good faith and in the exercise of honest judgment in the lawful and legitimate furtherance of corporate purposes.” Auerbach v. Bennett, 47 N.Y.2d 619, 629, 631 (1979) (“[B]y definition the responsibility for business judgments must rest with the corporate directors … [and] absent evidence of bad faith or fraud … the courts must and properly should respect their determinations.”) It may be that you simply do not have the facts to pursue this relief. So what’s next? Dissolution may be the only option. It should be noted that together with a dissolution action, you may commence a hybrid action seeking dissolution as well as damages due to the failure of the other shareholder to distribute funds in the event you have evidence other distributions were made to that shareholder and not to your client. Under BCL §1104, a 50 percent shareholder may present a petition for dissolution on one or more of the following grounds: (1) that the directors are so divided respecting the management of the corporation’s affairs that the votes required for action by the board cannot be obtained; (2) that the shareholders are so divided that the votes required for the election of directors cannot be obtained; (3) that there is internal dissension and two or more factions of shareholders are so divided that dissolution would be beneficial to the shareholders. Your first hurdle would be to establish that the oral agreement your client mentioned, which would make her a 50 percent shareholder, is valid. UCC §8-113 replaced UCC §8-319 (repealed eff. 1997), providing that the “Statute of Frauds [is Generally] Inapplicable” to securities. The new statute provides that “[a] contract or modification of a contract for the sale or purchase of a security is enforceable whether or not there is a writing signed or record authenticated by a party against whom enforcement is sought, even if the contract or modification is not capable of performance within one year of its making.” You may simultaneously seek relief under BCL §1104-a, which provides that a shareholder, like your client, who owns at least 20 percent of the outstanding shares, may seek dissolution if: (1) The directors or those in control of the corporation have been guilty of illegal, fraudulent or oppressive actions toward the complaining shareholders; (2) The property or assets of the corporation are being looted, wasted, or diverted for non-corporate purposes by its directors, officers or those in control of the corporation. You probably will start with asserting that your client has been subjected to oppressive actions and hopefully have some evidence that assets are being wasted. Oppression occurs “when the majority conduct substantially defeats expectations that, objectively viewed, were both reasonable under the circumstances and were central to the [minority shareholder’s] decision to join the venture.” Matter of Kemp & Beatley (Gadstein), 64 N.Y.2d 63, 73 (1984); see also Matter of Charleston Square, 295 A.D.2d 425, 426 (2d Dep’t 2002). A bonus under this section is that, in addition to all other disclosure requirements set by the court, the company must make available for inspection and copying the corporate financial books and records for the three preceding years no later than 30 days after the filing of a petition. McKinney’s BCL §1104-a(c). However, if you bring a BCL §1104-a proceeding, the other shareholder may elect to buy out your client under BCL §1118 and the valuation date, in that event, will be one day before the petition was filed. Any increase in value after that date will be simply out of reach for your client. A §1118 election is not available in a §1104 dissolution. Finally, you have additional arrows in your quiver if you seek dissolution under either §§1104 or 1104-a, such as seeking the appointment of a receiver, McKinney’s BCL §1113, the potential imposition of a constructive trust, see Cortes v. 3A North Park Ave Rest, 46 Misc.3d 670, 703-04 (Sup. Ct., Kings Cty., 2014), an injunction limiting the actions of the present board and officers of the company (McKinney’s BCL §1115) and requesting that the opposing party post a bond in the amount of the value of your client’s shareholder’s interest in a §1118 election (McKinney’s BCL §1118(c)(2)). However, the process will be long, no matter how you slice it.

Your Client and Her LLC Interest

Let’s say your client told you instead that she is a member of an LLC. What are her rights then? Without an operating agreement, your client’s claim will be governed by New York’s Limited Liability Company Law. Interestingly, the Court of Appeals held in 2008 that LLC members may bring derivative suits on the LLC’s behalf even though the State Legislature considered and rejected including such a right in the law. Tzolis v. Wolf, 10 N.Y.3d 100 (2008). However, the same rules apply to such an action here, to wit, that the allegations must be specific and the business judgment rule is always in play. Next, can your client seek dissolution? A court may order the 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.” N.Y. Limit. Liab. Co. Law §702. The statute does not define the term “reasonably practicable.” In determining whether a limited liability company should be dissolved, the court is determining whether it is or is not “reasonably practicable for the company to continue to carry on its business” and not whether it is impossible. Matter of 1545 Ocean Ave., LLC, 72 A.D.3d 121 (2d Dep’t 2010); see also Matter of Kassab v. Kasab, 137 A.D.3d 1135 (2d Dep’t 2016). While the court will look to the operating agreement initially to determine what the purpose of the LLC is, here, the court will have to examine extrinsic evidence to determine that purpose. “[T]he dissolution of a limited liability company under [LLC] §702 is initially a contract-based analysis.” 1545 Ocean, 72 A.D.3d at 128; Matter of Eight of Swords, LLC, 96 A.D.3d 839 (2d Dep’t 2012) (the court used extrinsic evidence to determine the LLC’s primary purpose). The petitioner in an LLC dissolution proceeding must either show that “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 [that] continuing the entity is financially unfeasible” 1545 Ocean, 72 A.D.3d at 131. This is a very high burden. If the company is performing fine financially and doing what it set out to do, the fact your client has not received a distribution probably will not be enough to carry the day in a dissolution proceeding. Your client’s allegations of oppressive conduct or that she is being frozen out by her other member will not state cognizable grounds for dissolution. Belardi-Ostroy, Ltd. v. American List Counsel, Inc., 2016 WL 1558850 (Sup. Ct., N.Y. Cty, 2016).

Conclusion

Based on the law, your client is in for a fight if the other side has no interest in relenting. She also has one hand tied behind her back as a result of failing to insist on written agreements that clearly set forth her rights and her fellow shareholder’s obligations. You would be surprised how many people think, including those who you would consider to be “sophisticated,” that buying into a closely-held corporation is like buying shares in IBM. Therein lies the lesson—if your client thought she was saving money upfront by going ahead without legal advice, she will pay far more on the back end trying to salvage the investment of her hard-earned money. Paul F. Millus is a shareholder of Meyer, Suozzi, English & Klein, P.C., and practices in the firm’s litigation and employment law departments.