As we have often noted on this blog, the importance of businesspeople setting all the terms of their agreements into a writing cannot be overstated. If a term is not in a written agreement – such as a requirement that all partners must actually work for a company rather than be a passive investor – with limited exceptions, the term might as well not exist. A recent decision in a “business divorce” case pending in the Commercial Division of the New York County Supreme Court is the latest reminder of the wisdom of a signed writing.
In Stavroulakis v. Pelakanos, et al., 2018 N.Y. Slip Op. 50180(U) (Sup. Ct. N.Y. Co. Feb. 13, 2018), plaintiff – a minority member of the company that owned and franchised the Bareburger restaurant brand – sued the other shareholders alleging they transferred all the assets of the company (including the rights to franchise royalties and the Bareburger Trademark) without consideration to a new entity formed by the other shareholders that did not include plaintiff. Plaintiff alleged, among other claims, that his partners breached their fiduciary duties to plaintiff and the company by self-dealing, usurping corporate opportunities and engaging in corporate waste. The defendant-shareholders claimed they were justified in effectively kicking plaintiff out of the business because plaintiff had not performed any work and owed his equity stake in the company solely to an initial cash investment. Notably, however, the company’s written agreement did not require any shareholder to work for the company. Nonetheless, defendants argued the “business judgment rule” – a doctrine prohibiting courts from inquiring into the internal business decisions of a company – protected their actions against plaintiff.
The Court disagreed with defendants and skewered their defense. The Court noted that the business judgment rule only protects acts taken in good faith and in legitimate furtherance of corporate purposes. The Court held that transferring the assets of the company to a new entity for no consideration solely to exclude plaintiff because he did not work for the company was not done in good faith or in the interest of the company. Further, defendant-shareholders all had a personal interest in the transaction – each shareholder’s interest in the business increased by eliminating plaintiff – barring application of the business judgment rule. Accordingly, defendants had the burden of proving the “entire fairness” of the transition to the company and plaintiff.
Defendants did not attempt to prove the fairness of the process of the transaction (done behind plaintiff’s back) or the price for the transaction (none). Defendants, rather, argued it was “fair” to cut out plaintiff because he had not worked for the company. The Court summarily dispensed with that defense because none of the company’s written agreements, nor the Business Corporation Law, obligated any shareholder to perform work for the company. To the contrary, the Court found that when the company was formed, the parties understood that only some of the shareholders would work for the company and would receive a salary unrelated to their economic interests as shareholders. The Court granted plaintiff partial summary judgment holding the transfer of assets for no consideration was not fair and breached defendants’ fiduciary duties. The Court noted the company’s agreements could have obligated shareholders to work or, alternatively, defendant-shareholders could have bought out plaintiff or engaged in a “freeze-out” merger (a strategic merger conducted to eliminate unwanted minority shareholders, the mechanics of which are beyond the scope of this post). The Court, relying on the precedent setting decision obtained by Frydman LLC in Yudell v. Gilbert, 99 A.D.3d 108 (1st Dep’t 2012), held plaintiff could recover damages against defendants derivatively on behalf of the company because the company suffered the harm of loss of its assets. The Court also determined plaintiff could recover money damages based on defendants’ oppression of plaintiff as a minority shareholder. The Court held off determining which type of recovery was appropriate until after trial.
If you have any questions about disputes among business partners, the best ways to avoid them or a partner’s rights in trying to resolve them, please do not hesitate to contact us.
This is the five year anniversary of the decision obtained by Frydman LLC in Yudell v. Gilbert, 99 A.D.3d 108, 949 N.Y.S.2d 380 (1st Dep’t 2012), where we successfully defended a joint venture partner and property manager of a shopping center on Long Island. The plaintiff, a minority joint venturer, asserted breach of fiduciary duty and other claims based upon alleged improper management of the shopping center. A core issue was whether the claims were direct (held by the partner) or derivative (where the partner was seeking to enforce a claim held by the joint venture and affecting all of the joint venturers). If it was a derivative claim, the plaintiff would have to explain why he failed to simply demand that the joint venture bring the claim. Derivative claims are a potent weapon for shareholders to redress mismanagement and self-dealing in corporations – from IBM to family owned companies.
Frydman LLC moved to dismiss the complaint on the basis, among others, that the claims were derivative, or owned by the joint venture, and plaintiff failed to properly plead that it would have been futile for plaintiff to demand that the joint venture bring the claims. The trial court agreed, granted our motion and dismissed the case. The appellate court affirmed.
While there were some other novel issues, in adopting our arguments the appellate court noted that “New York does not have a clearly articulated test” for determining whether a shareholder claim is direct or derivative (despite the prevalence and importance of such claims in corporate litigation). The appellate court made a precedent setting holding by adopting the test used by Delaware courts set forth in Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031 (Del. 2004) to determine whether a claim is direct or derivative: (1) who suffered the harm? (e.g. the company or the shareholders) and (2) who would receive the benefit of recovery? (e.g. would the recovery go to the company or the shareholders). The appellate court upheld the trial court’s holding that plaintiffs’ claims were derivative because (1) the joint venture suffered the alleged harm caused by the mismanagement and (2) any potential recovery would go to the joint venture because “It is only through loss to [the joint venture] that plaintiffs suffer a loss at all … all members suffer losses from the failure to collect rents and other obligations owed the joint venture.”
It is gratifying to see that the Yudell holding has provided much needed clarity in the area of derivative litigation in New York, home to very significant corporate litigation, and has been cited some 100 times by state and federal courts, taught in corporate law classes and discussed in many legal publications.
If you have questions about the direct/derivative claim distinction or the ability to bring suit concerning a business dispute, please do not hesitate to contact us.
Tags: Business Litigaiton, Corporate Litigation, Derivative Claims, Direct Claims
THE IMPORTANCE OF IMPLEMENTING A LITIGATION HOLD
With the proliferation of email communication and other electronically stored information (“ESI”), litigation over the handling of ESI has also grown in scope, complexity and expense. In this post, we discuss the issue of the destruction of ESI, making relevant documents unavailable for exchange in pre-trial discovery. Clearly, a party found to have intentionally deleted incriminating email is subject to serious sanction by the courts. Inadvertent destruction of ESI, such as failing to shut off an auto-delete function in Outlook or on a backup drive, can also land a party in hot water.
The general rule is that a party should implement a “litigation hold” when it reasonably anticipates litigation. The litigation hold should be crafted with counsel and delivered to all potential document custodians or persons that might have relevant ESI or other documents. Oftentimes, counsel will need to consult with IT staff to understand a client’s network architecture and develop protocols to ensure overwrite, delete or other functions are disabled and to collect and preserve potentially relevant ESI for review by counsel or other qualified persons.
In the seminal 2003 decision in Zubulake v. UBS Warburg LLC, 220 F.R.D. 212 (S.D.N.Y.), the Federal District Court in Manhattan held that “[o]nce a party reasonably anticipates litigation, it must suspend its routine document retention/destruction policy and put in place a ‘litigation hold’ to ensure the preservation of relevant documents.” The Zubulake decision has been followed by the courts in New York and across the country.
In VOOM HD Holdings LLC v. EchoStar Satellite L.L.C., 93 A.D.3d 33, 939 N.Y.S.2d 321 (1st Dep’t 2012), defendant started sending notices to plaintiff of alleged breaches and termination of the parties’ agreement for the distribution of television programming over a satellite network. Defendant, however, did not issue a litigation hold letter to its employees until after the start of the lawsuit and did not suspend email auto-delete until four months after the lawsuit started. Defendant also allowed its employees to unilaterally determine which emails should be preserved, instead of collecting all potentially relevant documents. Potentially relevant email were lost. Defendant’s main defense was that it did not expect full blown litigation because it was in heavy settlement discussions with plaintiff.
The appellate court covering Manhattan and Bronx adopted Zubulake and held that a party “reasonably anticipates litigation” when it is on notice of a “credible probability” that it will be involved in a lawsuit, seriously contemplates commencing a lawsuit or takes specific actions to commence a lawsuit. The court found the defendant reasonably anticipated litigation when it started sending termination and breach notices and itemized a laundry list of defendants’ failures in not putting in place a comprehensive litigation hold. The court affirmed the lower court’s sanction of the defendant for its spoliation of ESI by granting that an adverse inference instruction against defendant would be issued at trial, i.e. an instruction to the trier of fact to assume the unpreserved document was adverse to the party.
It is critically important that a party facing any prospect of business litigation consult early on with an experienced litigation attorney about a proper litigation hold. If you have any questions regarding litigation holds and the preservation of documents, please do not hesitate to contact us.
Sometimes when partners are starting up a business, they fail to follow corporate formalities. Whether because of a lack of funds, lack of attention to detail, lack of time, lack of desire to crimp new business relationships or simply a lack of desire, corporate founders can fail to exercise various good corporate governance practices. Written agreements among owners are vital to make clear (and enforceable) the agreements between new partners in a startup company, and can be especially important to minority partners. One of the reasons that limited liability companies have become the go-to corporate form is because the New York Limited Liability Company Law allows tremendous flexibility in the terms of operating agreements – the agreements governing the relationship between the members of the company. But, to take advantage of these vast corporate governance rights, the LLC Law states that operating agreements have to be in writing.
A New York plaintiff in 2015 came to learn the downside to laxity in demanding a written agreement when a limited liability company is formed. In Shapiro v. Ettenson, 2015 N.Y. Slip Op. 31670(U) (Sup. Ct. N.Y. Co. Aug. 16, 2015), aff’d 146 A.D.3d 650, 45 N.Y.S.3d 439 (1st Dep’t 2017), three founding members, each with an equal 1/3 ownership interest, formed a limited liability company. Two years later and without prior notice, the plaintiff received a notice from the two other members stating that they had adopted a written operating agreement, which provided for management action to be approved by only a majority in interest of the members. A year later, the two other members provided notice to the plaintiff, pursuant to the new operating agreement, stating that the other members (constituting a majority in interest) voted to issue a capital contribution call and that plaintiff’s equity interest would be diluted if he failed to make the capital call and another member did so in his place.
The plaintiff refused to recognize the validity of the operating agreement and make the capital call pursuant to the agreement. The other two members diluted the plaintiff’s membership. The plaintiff sued claiming that the three members orally agreed that such decisions would require unanimous consent (a common provision with two or more members with equal membership interests).
The case started in a Manhattan trial part and ended in an appeal to the First Department Appellate Division (the appellate court that covers New York County and Bronx County). The appellate court affirmed the holding of the trial court that the alleged oral agreement requiring unanimity in corporate decision-making was void and unenforceable under the New York LLC Law. The LLC Law expressly provides that in the absence of a written operating agreement, action may be taken after a vote of the majority in interest of the members (i.e. over 50%). The court found the defendant members, collectively holding a majority interest, properly adopted the operating agreement, made the capital call and diluted the plaintiff’s membership interest – all without notice to the plaintiff and without the plaintiff’s consent.
Frydman LLC recently secured a multi-million dollar recovery for our client in an arbitration claim against a former partner. One of FLLC’s practice concentrations is “business divorces,” where one or more partners leave a company. Our client was a 50/50 member with his business partner in a real estate development company in the New York City metro area. The company had successfully co-developed a sizeable residential project and was advancing a co-development of a large ground up mixed-use project. The partners accused each other of misconduct, and ended up bringing claims against each other pursuant to an arbitration provision in the company’s operating agreement. On behalf of our client, we alleged causes of action including breach of fiduciary duty and usurpation of corporate opportunity, claiming the former partner abandoned the company and cut out our client by co-developing the mixed-use project through a different entity – one wholly owned by the former partner.
Discovery in the arbitration was hard fought, eventually leading the Panel to appoint a “Big Four” accounting firm to act as electronic discovery master. We engaged in repeated discovery motion practice and, after months of document discovery disputes, engaged in the exchange of approximately twenty gigabytes of electronic data, comprising well over 100,000 documents. After completion of depositions of the parties, we conducted a two week arbitration hearing before the three member arbitration Panel. The hearing included the testimony of seven witnesses, some 300 exhibits and extensive closing argument. We also engaged in months of post hearing briefing, amounting to over 120 pages of fact and legal argument.
In its reasoned twenty-one page Award, the Panel granted our client’s claims and dismissed the claims of the former partner. The Panel found that the former partner stole the mixed-use development project from the company, cut out our client and acted as a “faithless servant.” Among other relief, the Panel awarded our client $400,000 of punitive damages based upon the former partner’s egregious breaches of fiduciary duty, assessed discovery costs against the former partner for electronic discovery violations and placed the contested interest in the mixed-use project in a constructive trust for the benefit of the company and our client. We successfully confirmed the Award in New York State Court, which entered judgment on the Award.
After a formal mediation and months of negotiation, the parties recently closed a settlement whereby our client kept the company and its interest in the completed residential project, and the former partner kept the interest in the mixed-use project while making a multi-million dollar cash settlement payment to our client. Although the resolution took a number of years and much intensive work, we are gratified that our client was vindicated and justly received significant compensation.
Prior results do not guarantee a similar outcome.