- With Sir Blackstone’s Help, Court Thwarts Minority Shareholder’s Effort to Block 1031 Exchange
- September 4, 2013 | Author: Peter A. Mahler
- Law Firm: Farrell Fritz, P.C. - New York Office
It’s safe to say the pre-eminent English jurist, Sir William Blackstone (1723-1780), knew beans about like-kind exchanges under Section 1031 of the U.S. Internal Revenue Code or minority shareholder rights under New York’s Business Corporation Law although, to be fair, neither of those laws (or country or state for that matter) existed in his time.
Which makes it all the more fascinating that his greatest work, Commentaries on the Laws of England, was cited as authority in a recent decision by a New York judge weighing a dispute between majority and minority factions of a close corporation over whether the latter’s consent was required for the corporation’s sale of its sole realty asset and purchase of a replacement property as part of a so-called 1031 exchange. I’ll begin with some background information:
What is a 1031 Exchange? The 1031 exchange is a popular tax planning device for owners of realty and other qualified business assets with built-in gains. The tax code permits a property owner to defer taxes on the gain from a sale of property used in a trade or business or for investment if, within 180 days, the sale proceeds are reinvested in similar property. As explained on an exchange intermediary trade association website:
"The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer’s investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a “paper” gain.
When is Shareholder Consent Needed for a Sale? The general rule is stated in § 909(a) of the Business Corporation Law. The statute provides that upon a
"sale, lease, exchange or other disposition of all or substantially all the assets of a corporation, if not made in the usual or regular course of the business actually conducted by such corporation,
the transaction must have both board approval and shareholder consent. For corporations in existence before 1997, the statute requires consent by shareholders holding two-thirds of the outstanding voting shares. For corporations formed after the statute’s amendment in 1997, only majority approval is required.
The Theatre District Case
Theatre District Realty Corp. v. Appleby, 2013 NY Slip Op 31979(U) (Sup Ct NY County Aug. 20, 2013), decided last month by Manhattan Commercial Division Justice Melvin L. Schweitzer, involves a corporation called Theatre District Realty Corp. formed in 1993 to own and operate a mixed-use commercial building on the West Side of lower Manhattan. The corporation, which owns no other assets, has two shareholders: a testamentary trust holding 55% of the corporation’s shares, and Ilana Appleby holding the other 45%. The corporation’s two directors are trust beneficiaries.
According to Theatre District’s complaint, the building requires costly renovation and cannot turn a profit in any event because most of the building’s residential units are rent regulated. The trustee of the majority shareholder and the two directors determined that a profitable arrangement could be made by effectuating a tax-deferred 1031 exchange under which the building would be sold and the proceeds used to purchase another income-producing property.
The complaint alleges that a number of potential buyers came to satisfactory terms but none would enter into a contract of sale without the consent of all shareholders because of the possibility that the sale of the corporation’s sole asset fell within BCL § 909(a). Since the corporation pre-dates the statute’s amendment in 1997, the consent of the 45% shareholder, Appleby, was required to attain two-thirds approval. Allegedly, Appleby refused to give consent except on terms that made the building unsalable.
Theatre District’s complaint sought a declaratory judgment that § 909(a) is inapplicable, and that Appleby’s consent therefore is not required, because the building’s sale as part of a 1031 exchange will be made in the “usual or regular course of the business actually conducted by Theatre District, and will not result in the liquidation or distribution of the corporate assets.”
Theatre District’s Summary Judgment Motion
Theatre District moved for summary judgment on its claim for declaratory relief. Its memorandum of law noted that the corporation expressly is authorized by its certificate of incorporation to “purchase, lease, rent, exchange or otherwise acquire real estate . . . and to sell, rent, lease, mortgage, exchange . . . or otherwise dispose of such real estate.” It argued that the proposed 1031 exchange was consistent with such authorization, that it would continue rather than terminate Theatre District’s business, and that it was in the ”usual and regular course of business” thereby rendering inapplicable § 909(a)’s super-majority consent requirement.
In her opposing memorandum, Appleby contended that the language of § 909(a), and especially the addition of the phrase “business actually conducted,” was intended to overrule prior case law that had construed the BCL’s predecessor statute as not requiring shareholder consent when a single-asset realty corporation, whose certificate authorizes a realty ”exchange,” seeks to sell its property and purchase a replacement property. In other words, Appleby argued, § 909(a) requires the court to look to the corporation’s actual activities rather than those authorized by the organizational document, to determine whether a proposed action is made in the regular course of business. Since the only business conducted by Theatre District since its formation in 1993 was the ownership and operation of the one property, Appleby concluded, its proposed sale triggered the shareholder-consent requirement.
Justice Schweitzer’s Ruling
In his six-page Decision and Order, Justice Schweitzer began his analysis by observing that
"[b]oth parties agree that the regular course of business actually conducted for Theatre District is to lease residential and commercial space, thus making the pivotal issue whether the transaction is in furtherance of the objectives of Theatre District’s existence.
Justice Schweitzer next addressed whether, as District Theatre would have it, the transaction at issue was an “exchange” or, as Appleby characterized it, a ”sale.” Here’s where Justice Schweitzer invoked Sir William Blackstone:
"It is germane to the discussion to define the terms “sale” and “exchange.” In his Commentaries, Blackstone stated, “[sale] or exchange is a tran[s]mutation of property from one man to another, in con[s]ideration of [s]ome recompen[s]e in value: for there is no [s]ale without a recompen[s]e; there mu[s]t be quid pro quo.” A thorough analysis of Blackstone determines that the transaction at hand is a sale, not an exchange as the Theatre District has cast it.
Ultimately, however, the characterization of the transaction as a sale did not redound to Appleby’s benefit. Instead, Justice Schweitzer found guidance by analogy to Barasch v. Williams Real Estate Co., 33 Misc 3d 1219 (A) (Sup Ct NY County 2011), aff’d, 100 AD3d 562 (1st Dept 2012), in which the court opined that a sale transaction does not require shareholder consent “where it does not result in the liquidation in whole or part of the company’s business” and “where a corporation retains value approximately equal to the asset sold.” In the case before him, Justice Schwietzer summed up, shareholder consent is not required because
"the property is not being sold to liquidate the assets of Theatre District, but instead to reinvest the assets in a similar property that is better suited to provide significant profits for the shareholders. This sale and subsequent purchase of a more profitable property that will be used in the same manner satisfies the requirement that the transaction be in furtherance of the purpose of Theatre District’s existence.
. . . Because the sale as proposed is in the regular course of business actually conducted by Theatre District, and is also in furtherance of the objectives of its existence, the transaction does not fall under BCL Section 909(a), and the sale does not require supermajority consent of shareholders.
The Importance of Theatre District
Theatre District appears to be a case of first impression. Neither the parties’ briefs nor the court’s decision cites any controlling case authority applying BCL § 909(a) to similar facts. In the Barasch case cited in the decision, the court held that a highly complex corporate reorganization, designed to transfer majority ownership of a very large realty management and brokerage company, unlike in Theatre District, constituted a sale within § 909(a) thereby triggering dissenting shareholder appraisal rights.
Theatre District therefore may represent a very important decision, given the legions of closely held realty corporations formed to own and operate a single property, essentially by creating a default rule that gives those in control of the corporation the authority to effectuate a 1031 exchange without seeking or obtaining shareholder consent. Minority shareholders who wish to have a meaningful voice in a decision to sell a realty corporation’s sole asset and use the proceeds to acquire another would be well advised to negotiate appropriate protection either in the certificate of incorporation or in the shareholders’ agreement.
One final observation: By and large, the limited liability company has surpassed the corporation as the entity of choice for realty holding firms as well as for many other types of businesses. The LLC Law’s default rule analogous to BCL § 909(a) is found in LLC Law § 402(d)(2) which, unless otherwise provided in the operating agreement, requires a majority vote of the members to “approve the sale, exchange, lease, mortgage, pledge or other transfer of all or substantially all of the assets of the limited liability company.” Note that the statute lacks the additional verbiage found in § 909(a), which was the focus of the Theatre District court’s ruling, limiting its application to transactions ”not made in the usual or regular course of the business actually conducted by such corporation.” In other words, under the default rule a 1031 exchange involving a single-asset realty LLC would require member approval in all events, albeit approval by a 51% member would suffice.