And the Award For Most Oppressive Conduct By a Majority Shareholder Goes to . . .

Farrell Fritz, P.C.
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Over the years I’ve litigated and observed countless cases of alleged oppression of minority shareholders by the majority. Oppression can take endlessly different forms, some more crude than others in their execution, some more draconian than others in their effect.

If there was an award for the crudest and most draconian case of shareholder oppression, Matter of Twin Bay Village, Inc., 2017 NY Slip Op 06024 [3d Dept Aug. 3, 2017], decided earlier this month by an upstate appellate panel, would be a serious contender.

The case involves a bitter dispute between two branches of the Chomiak family over a lakefront resort called Twin Bay Village located on beautiful Lake George in upstate New York. In 1957, the husband-and-wife founders, Stephan and Eleonora Chomiak, opened the summer resort on land they owned. They and their two sons, Leo and Vladimir, together ran the business until 1970 when they transferred ownership of the land and business to newly-formed Twin Bay Village, Inc. owned 26% by each parent and 24% by each son.

Brothers Leo and Vladimir each had two children, all of whom grew up working at the resort each summer. In 1974, following Stephan’s death, share transfers resulted in Leo and his two children, and Vladimir and his two children, each owning 50% directly or in trust.

By the mid-1980’s, however, Vladimir and his two children stopped working at the resort, Vladimir to pursue a career as a land surveyor and his two children eventually pursuing other educational and career opportunities. When Vladimir stopped working at the resort, he transferred two shares to his brother Leo giving him and his family a combined 52% controlling interest. According to Vladimir’s trial testimony, he gave the shares to Leo so that Leo would have management control and could therefore “protect” Vladimir’s two children as trustee over their shares.

Ever since the 1980’s, Leo (who died in 2011), his wife and two children operated the resort and handled all of the corporation’s business and financial affairs with no help, involvement or oversight by Vladimir or his two children. With one or two exceptions, and until the dispute flared up in 2009, Vladimir and his children didn’t receive notices of shareholder meetings or ask for meetings; didn’t vote or ask to vote; didn’t receive or request financial reports; didn’t receive distributions after 1996 or complain about getting none; and didn’t receive or request tax returns of the corporation which filed as a C corporation and therefore didn’t issue shareholder K-1s.

Outwardly, it’s as if they wanted nothing to do with the business. Meanwhile, Leo and his family plugged away, year after year, maintaining the property and running the resort.

The Oppression

While plugging away at the business, Leo and his two daughters for their own benefit also plugged away at diluting and devaluing the 48% stock interests of brother Vladimir and his two children. They did so under the self-professed belief, as described in the court-appointed referee’s detailed post-trial Findings of Fact and Conclusions of Law, that their “lifetime devotion” and “sweat equity,” in contrast to Vladimir and his family’s “abandonment” of the enterprise, “entitled” them to financial benefits “superior to those of the passive shareholders/family members.”

Here’s what they did:

  • At a shareholders meeting in 1996, of which no notice was given to the minority shareholders, they terminated shareholder dividend payments, never to be resumed, falsely claiming at the hearing that they did so on the advice of the company’s outside accounting firm.
  • At a shareholders meeting in 2001, of which no notice was given to the minority shareholders, they voted to pay themselves annual bonuses totaling $80,000 that would continue year after year without regard to individual or company performance or the company’s ability to pay, also without any input from their accountant.
  • The referee found that the bonuses were never paid and instead were meant either to accumulate as company debt to be paid upon the sale or liquidation of the company, or “to lower the value of the Corporation’s stock so that [the minority shareholders] could be bought out at a low price well below the market value of the Corporation’s shares.”
  • Based on the company’s and their personal financial records and tax returns, the referee found that for many years, they “removed significant amounts of money from the Corporation ‘off the books’ for their personal benefit” including diverting cash payments by resort guests. He also found they hid these dealings from tax authorities with false book entries including grossly understated company revenues and fictitious shareholder loans using company money that were intended to burden the company with debt payable to themselves upon a sale or to force a buy-out of the minority stakeholders for less than the actual value of their shares.
  • At a 2004 shareholders meeting, of which no notice was given to the minority shareholders, they authorized the issuance of 100 additional shares to themselves and to Leo’s wife, thereby increasing their family ownership stake from 52% to 76% and diluting that of Vladimir and his children from 48% to 24%. Vladimir and his children did not learn of the recapitalization for at least a decade.
  • Vladimir’s family claimed to have paid $3,000 per share for the 100 additional shares, but the referee found that the payments came from company funds that they took without reporting it as income to themselves.
  • In addition, the assigned value of $3,000 per share, which they picked without professional assistance, grossly understated the shares’ fair market value at a time when, as the referee found, they were marketing the resort for sale for $4.6 million and “knew that the Corporation held real estate and other securities and property worth well in excess of” the assigned enterprise value of $600,000.
  • They spent up to $200,000 of company funds planning a subdivision and residential development on part of the land owned by the company, with the ultimate plan to keep part of it for their own use, without telling the minority shareholders.
  • For their pièce de résistance, in 2009 they sent to the minority shareholders, who resided in Florida, short notice of a shareholders meeting for the purpose of amending the by-laws to adopt provisions, among other things, for the sale and purchase of shares in the event of a shareholder’s “cessation of involvement in the business affairs of the Corporation.” At the meeting, without the minority shareholders present, they adopted the new by-laws and approved a resolution compelling the minority shareholders to redeem their shares for a little over $1,100 per share supposedly representing “book value” based on the company’s inaccurate financial statements. They then had an attorney send the minority shareholders a letter demanding they sell the shares on those terms.
  • Meanwhile, they did not propose a similar resolution or make a similar demand on the father, Leo, even though his involvement with the company’s business affairs had ended years before. Additionally, when Leo died in 2011 amidst litigation between the two families, they didn’t disclose his death to the minority shareholders for over six months in an effort to defeat the minority shareholders’ rights under a pre-incorporation agreement to purchase the decedent’s shares.

The referee concluded his exhaustive post-trial reporting with a recommendation that the 2004 issuance of 100 shares be set aside; that the majority shareholders’ purported loans, unpaid bonuses and salary totaling around $800,000 also be set aside; that liquidation of the company is the only feasible means to protect the rights and interests of the minority shareholders; and that the court’s order of dissolution should be conditioned upon affording the majority shareholders an opportunity to purchase the minority shares at fair value. The lower court subsequently entered an order adopting the referee’s recommendations, and the majority shareholders appealed to the Albany-based Appellate Division, Third Department.

The Appellate Court’s Ruling

In a signed opinion by Justice Robert S. Rose, the appellate court unanimously affirmed the lower court’s order of dissolution. Here are some of the highlights:

  • The court agreed with the appellant majority shareholders that Vladimir’s two children lacked standing to seek judicial dissolution because their shares were held in trust and they had no voting rights, but then concluded it made no difference because the trustee, Vladimir, possessed voting rights and was a named petitioner.
  • The court also rejected the majority shareholders’ argument that the dissolution proceeding was time-barred, holding that the applicable six-year statute of limitations did not commence until the 2009 attempted force-out of the minority shareholders.
  • In its discussion of the “reasonable expectations” standard under the oppressed minority shareholder statute, the court observed that “this standard is equally applicable to passive shareholders . . . inasmuch as the standard is not focused on the complaining shareholders’ level of involvement with the corporation, but, rather, their reasonable expectations and whether those expectations were defeated.”
  • The court found “no reason to disturb” the lower court’s determination that the minority shareholders’ “reasonable expectations were substantially defeated by [the majority’s] oppressive actions in 2001, 2004 and 2009 inasmuch as those actions intentionally diluted and ultimately sought to extinguish [the minority’s] ownership interest in the corporation.”
  • The court also upheld the lower court’s conclusion that the majority shareholders looted corporate assets for non-corporate purposes and that, together with the majority’s oppressive actions, such conduct justified setting aside the 2004 stock issuance along with the purported shareholder loans and unpaid bonuses and salary.

Closing Thoughts

Especially in family-owned businesses, where some members of succeeding generations inherit shares despite having no desire or ability to work inside the business or participate at the board level, it’s only natural that the interests and attitudes of the active inside shareholders and the passive outside shareholders can diverge to the breaking point. The potential for hostilities is even greater when, as in Twin Bay Village, the passive outsiders pay no heed to company affairs over an extended time period, seemingly giving license to the insiders to do what they will.

In my view, the most important lesson of Twin Bay Village is that no such license exists, and that, however hard they labor in contrast to the outside passive owners, and however deserving they may feel, the controllers of a close corporation have immutable fiduciary responsibilities that do not admit of self-dealing and self-advancement at the other shareholders’ expense. As the referee eloquently wrote in his report:

The passivity of Petitioners, the minority shareholders, and the lifetime devotion of the Respondents, the majority shareholders, is not a legal justification for a breach or abandonment of the fiduciary obligations of the Respondents to the minority in their capacity as Officers and Directors of Twin Bay Village. The disparity in investment of personal time is likewise not a justification for failing to meet the obligations of disclosure and fair dealing that is imposed upon the Respondents as officers of the Corporation.

Twin Bay Village is an exaggerated version of a recurrent problem in all types of closely held business entities when there’s a significant disparity between, on the one hand, each owner’s contribution of money and/or sweat and, on the other hand, each owner’s equity stake. As always, the only truly effective preventative is a carefully drawn and regularly updated shareholder or operating agreement together with careful succession and estate planning in the case of a family-owned business.

My thanks to Benjamin Joelson, Esq. of Akerman LLP, attorney for the minority shareholders in Twin Bay Village, for providing copies of the referee’s meticulous reports which, for those interested in learning more about the case, are well worth reading their combined 108 pages.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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