Minority Shareholders’ Derivative Suit Foiled by Voiding of Corporation’s Charter for Nonpayment of Taxes

by Farrell Fritz, P.C.
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[co-author: Franklin McRoberts]

A business’s failure to pay state taxes can be a problem if the entity later wants to bring a lawsuit, or its non-controlling owners want to sue on the entity’s behalf.

Under Section 203-a of the New York Tax Law, a New York business entity’s failure to pay franchise taxes for two years can result in automatic dissolution of the entity by proclamation of the New York State Secretary of State. Once a corporation is dissolved by proclamation for failure to pay franchise tax, it “does not enjoy the right to bring suit in the court of this state, except in [very] limited respects specifically permitted by statute.” Moran Enterprises, Inc. v Hurst, 66 AD3d 972 [2d Dept 2009].

What happens when an out-of-state entity, or shareholders on the entity’s behalf, attempt to sue in a New York court, despite the business not having paid taxes for several years in its home state? New York County Commercial Division Justice Anil C. Singh recently considering that question, specifically with respect to a Delaware entity, in Juma Technology Corp. v Servidio, Decision and Order, Index No. 151483/2016 [Sup Ct, NY County May 24, 2017].

Juma and the Transfer of Its Assets

Juma Technology Corp. (“Juma”) and two of its minority shareholders, suing derivatively on behalf of Juma, sued the majority shareholders and certain of its officers and directors. As explained in the briefs, which you can read here, here and here, the majority shareholders of Juma, a group of investment funds, originally were lenders to the business. The funds became equity owners through a series of debt and preferred equity investments totaling $25 million.

In 2012, the funds decided they could no longer loan Juma additional capital. When Juma was unable to repay its loans, the funds completed a strict foreclosure of the assets of Juma, which a majority of Juma’s board approved, resulting in the transfer of Juma’s assets to a new entity, after which the individual defendant officers and directors resigned from Juma and joined the new entity.

The Voiding of Juma’s Corporate Charter

Juma ceased to pay state taxes, racking up a delinquency of $400,000. Under a Delaware statute, 8 Del C. § 510, if a corporation fails to pay “any franchise taxes or taxes” for one year, then “the charter of the corporation shall be void.” On March 1, 2014, the Secretary of State of Delaware declared Juma’s corporate status “void” for failure to pay taxes.

Lack of Standing

Fast forward to 2016, when the minority shareholders of Juma sued in Manhattan Supreme Court, alleging that the strict foreclosure and transfer of assets from Juma to the successor entity constituted breaches of fiduciary duty, mismanagement, and waste. The various defendants, including the investment funds, filed three separate motions to dismiss the complaint. Only the funds’ motion to dismiss raised the issue of standing which ultimately became the knock-out punch.

Justice Singh held that because Juma’s corporate charter was declared void in 2014, “Juma does not have standing to sue.” The court explained that “under Delaware law, a corporation’s failure to pay taxes for one year will void its corporate charter and render inoperative all powers conferred upon it by law,” including its ability to bring lawsuits.

Noting that Delaware case law on the subject is “sparse,” the court relied primarily on a one-page decision of the Supreme Court of Delaware, which held that once a corporation is declared void under 8 Del C. § 510, it “has thereby ceased to exist and has lost any standing to appeal and be heard, even if represented by counsel.” Transpolymer Industries, Inc. v Chapel Main Corp., 582 A2d 936 [Del . Sup. Ct. 1990].

The Exception for Winding Up Corporate Affairs in Dissolution

Juma argued that it continued to have standing under a Delaware statute, 8 Del C. § 278, which states, “All corporations, whether they expire by their own limitation or are otherwise dissolved, shall nevertheless be continued, for the term of 3 years . . . for the purpose of prosecuting and defending suits . . . and of enabling them gradually to settle and close their business . . . .”

New York has a roughly analogous statute, Section 1006 of the Business Corporation Law, which the Court in Moran Enterprises held permits a corporation dissolved for failure to pay franchise taxes to continue to bring suits that “relate to the winding up of its affairs.”

But Justice Singh held that there was no such exception under Delaware law. As the Court explained,

Juma’s assertion that it was dissolved and should be given 3 years to prosecute this case pursuant to § 278 is unavailing. § 278 applies to corporations that ‘expire by their own limitation or are otherwise dissolved’ and not to corporations that are void.

As a result, the Court dismissed Juma’s claims. With respect to the minority shareholders’ claims, the Court held that the claims were derivative, not individual, because they “plead a wrong to the corporation only,” not the “breach of a duty independently owed to them.” Since the corporation lacked standing, the minority shareholders purporting to sue derivatively likewise lacked standing.

Outcome

Under both New York and Delaware law, an entity dissolved for failure to pay taxes can reacquire its status as an entity in good standing by paying all tax arrears. In Delaware, the notion is that a corporation voided for nonpayment of tax is “not completely dead,” but “in a state of coma from which it can be easily resuscitated.” Wax v Riverview Cemetery Co., 41 Del 424, 436 [Del. Super. Ct. 1942]. The rule protects entities (and their owners) from inadvertent nonpayment of taxes. Perhaps in part because of this rule, the Court in Juma dismissed the plaintiffs’ claims without prejudice. But the Court’s without-prejudice dismissal probably did not console the minority shareholders of an assetless entity, hundreds of thousands of dollars in tax arrears, with little likelihood of restoration to good-standing status.

[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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