• Court Compels Buyout Despite Consent to Dissolution
  • July 14, 2012 | Author: Peter A. Mahler
  • Law Firm: Farrell Fritz, P.C. - New York Office
  • Shareholder A and Shareholder B are the sole shareholders of On The Rocks Corp. After a period of growing hostilities, Shareholder A petitions for judicial dissolution of On The Rocks Corp. under §1104-a of the New York Business Corporation Law (BCL), which applies to illegal, fraudulent or oppressive conduct, as well as looting, waste and diversion of corporate assets by directors, officers or those in control of the corporation. By filing under §1104-a, Shareholder A hopes to induce Shareholder B, who for various reasons is the "natural" buyer of the business, to elect to purchase Shareholder A's stock interest for fair value under BCL §1118.

    But Shareholder B won't bite. Shareholder B believes that his best interests are served by allowing the court to proceed with dissolution and liquidation of On The Rocks Corp.'s assets. Shareholder B's lawyer therefore files an answer to the petition formally consenting to the dissolution. End of story? 

    Not necessarily, as illustrated in Matter of Zulkofske (The Brookhaven Agency, Inc.), 2012 NY Slip Op 51210(U) (Sup Ct Suffolk County June 28, 2012), decided last month by Suffolk County Commercial Division Justice Emily Pines. In Zulkofske, the petitioner requested, and Justice Pines granted, an order compelling the other shareholder to purchase the petitioner's shares for fair value determined by the court, notwithstanding the latter's non-election to purchase and consent to dissolution. Under what authority, you may ask, did the court act? And what were the specific circumstances in Zulkofske that led to this unusual result?

    The Brookhaven Agency, Inc.

    The Brookhaven Agency, Inc. ("Brookhaven") is a full service insurance agency in East Setauket, New York, incorporated in 1982 by Marian Zulkofske and her son, Peter, as 50/50 shareholders. In 2009, shortly before her death, Marian transferred her shares to a revocable trust which provided for distribution of the shares upon her death to her daughter, Virginia. By that time, Peter's son Nicholas also had joined the business as a licensed insurance broker.

    The Dissolution Proceeding

    In early 2010, Virginia filed a petition under BCL §1104-a seeking judicial dissolution of Brookhaven, an accounting and ancillary relief on the ground that her brother, Peter, had engaged in oppressive and fraudulent conduct. Peter initially opposed the petition, denying that grounds existed for dissolution and contesting his sister's standing as a 50% shareholder based on his mother's alleged incapacity at the time she executed the stock trust.

    In a decision dated June 3, 2010, Justice Pines upheld Virginia's standing to seek dissolution as 50% shareholder based on uncontested documentary evidence including the trust instrument and stock certificates.

    Peter's Eve-of-Trial Consent to Dissolution; Virginia's Buyout Demand

    Peter did not elect to purchase Virginia's shares under BCL §1118. The parties spent the next two or so years in discovery, and ultimately headed to trial in early June 2012 on the issues of whether grounds for dissolution existed and, if so, the appropriate remedy.

    Literally on the eve of trial Peter's lawyer delivered a letter to the court agreeing that grounds for dissolution under BCL §1104-a existed. The letter further stated that there was no need for trial and that the court should order a liquidation and accounting.

    Virginia, while agreeing that oppression had occurred, "vehemently objected" to the proposed liquidation. She contended that a compulsory buyout remedy should be considered by the court if it found that Brookhaven was a going concern, pointing out that she was ready to produce an expert witness to testify concerning the fair value of her shares.

    The Evidence at Trial

    The case proceeded to trial at which Virginia's sole witness was her valuation expert and Peter's sole witness was his son, Nicholas.

    Virginia's expert utilized a Discounted Cash Flow approach to value the insurance agency as a whole at $764,287, and Virginia's 50% interest at $382,000 without any discount for lack of marketability. The valuation included upward income adjustments for what he considered excessive commissions paid to the agency's producers most of whom were family members.

    Peter, whose primary position was that the court should liquidate Brookhaven, nonetheless challenged Virginia's expert's appraisal. First, through his son Nicholas's testimony, he sought to establish that Nicholas was a "self-employed" broker who was free to take his accounts with him to another agency, constituting 61% of the total value of all Brookhaven's accounts. Second, he contended that Virginia's expert should have applied a 30% marketability discount.

    Virginia's expert countered that Brookhaven's accounts belong to the corporation, not to the producers including Nicholas. He testified that, whenever accounts are owned by producers, it should be so indicated on the corporation's profit and loss statements, which was not the case with the Brookhaven statements provided  to him. He also testified that a marketability discount applies only to a minority shareholder, i.e., not to a 50% shareholder such as Virginia.

    The Court's Decision Compelling Buyout

    Justice Pines ruled for Virginia, ordering Peter to purchase her shares for $382,000.

    Her legal analysis cites the Court of Appeals' 1984 ruling in Matter of Kemp & Beatley, Inc., 64 NY2d 63, for the general proposition, that where oppression is established courts should evaluate if any remedy short of dissolution is appropriate. She also cites two cases for the specific proposition, that the court can compel a respondent to purchase the petitioner's shares even when the respondent does not elect to do so under BCL §1118: Matter of Wiedy's Furniture Clearance Center, Inc., 108 AD2d 81 (3d Dept 1985), and Matter of Harris (Charles R. Daniels Agency, Inc.), 118 AD2d 646 (2d Dept 1986).

    In Wiedy's, the court affirmed a forced buyout of the oppressed minority shareholder's interest after the controlling shareholders attempted a voluntary dissolution subsequent to the filing of the petition. The court found that "this remedy accommodates the interests of both parties by assuring that petitioner receives full credit for his ownership interest in the [corporation], and not just one third of the value of the remaining inventory, while respondents will be free to voluntarily dissolve the corporation after compensating petitioner, should they so choose."  The court in Harris did not compel a buyout as in Wiedy's, rather it affirmed the dismissal of a dissolution petition where the petitioner could obtain a fair return on his investment pursuant to the buy-out provisions of the shareholder's agreement.

    In Zulkofske, Justice Pines finds that Brookhaven is a profitable, going concern whose dissolution "is not a favored resolution of the matter." She further explains:

    [T]he Court believes that the Petitioners's request for a buyout of her shares by the corporation, is a better solution for the familial acrimony that has developed between Petitioner and the Respondent and permits the lucrative business to continue. This determination is also based upon another consideration. Respondent has taken the position that his son owns over 60% of the ongoing customer base and is free to leave the corporation and bring it with him. This Court has now found that the customer base is indeed an asset of Brookhaven Agency Inc. It is the Court's belief that the buyout remedy will better protect the Petitioner's interests under all of the circumstances.

    As mentioned in the quoted passage, Justice Pines did not accept Nicholas's testimony, which Peter used to challenge Virginia's expert's valuation, that Nicholas owns and is free to take elsewhere his customer accounts constituting the bulk of Brookhaven's income. Her finding, that "all of the business contained within the corporate book of business belongs to the Brookhaven Agency, Inc.," relies on evidence that the agency pays Nicholas's health insurance and commission on his sales; that his office and telephone are located at the corporate headquarters; that his business card says "Brookhaven Agency"; and that agency personnel provide him with clerical support.

    Justice Pines's decision fully endorses the $382,000 valuation of Virginia's shares by her expert, finding that the expert's adjustments to the commission income were "sensible" and his inclusion of all the customer accounts "credible". Justice Pines notes that she offered Peter the opportunity, which he declined, to delay presentation of his case to permit him to put on his own valuation expert.

    A Few Closing Thoughts

    • Zulkofske bears a likeness to Matter of Clever Innovations, Inc., 94 AD3d 1174, 2012 NY Slip Op 02536 (3d Dept Apr. 5, 2012), in which an appellate panel affirmed a compulsory buyout by the managing shareholder who controlled customer relations and who, as characterized by the court, sought "to avoid paying the [other shareholder] the fair value of its shares while personally continuing to profit by operating the company's business either individually or through a new corporation." Possibly the court in Zulkofske ascribed a similar motive to Peter's consent to dissolution while at the same time insisting that his son Nicholas owns most of Brookhaven's customer accounts.
    • Justice Pines's adoption of the expert's appraisal tacitly accepts his exclusion of a marketability discount, which the expert justified on the ground Virginia is not a "minority" shareholder. However, the theory behind the marketability discount, which is not without its critics, is that the discount is at the entity level, so the fact that Virginia holds a stock percentage below, at, or above 50% should make no difference.
    • Zulkofske is not your typical dissolution case involving 50/50 shareholders. Normally, we see two owners, both active in the business, each competing to buy out the other or to partition the assets. It is far more likely in such cases to see a petition brought under the deadlock statute, BCL §1104, rather than BCL §1104-a, for the simple reason that the former does not trigger the respondent shareholder's statutory right to purchase the petitioner's shares under BCL §1118. In Zulkofske, Virginia's decision to proceed under §1104-a makes sense since she was not active in the business and therefore her sole interest was in receiving cash for her shares.