The Cash-Out Merger Solution to the Problem Minority Owner

by Farrell Fritz, P.C.
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How can majority business owners legally rid themselves of a problematic minority owner? Not by transferring the business’s assets to another entity for no consideration. That was the conclusion of Manhattan Commercial Division Justice Shirley Werner Kornreich last month in a lawsuit over a minority shareholder’s stake in Bareburger, Inc., owner of its namesake restaurant chain.

The Bareburger Litigation

In Stavroulakis v Pelakanos, 2018 NY Slip Op 50180(U) [Sup Ct NY County Feb 13, 2018], Bareburger had no written shareholders agreement. Stavroulakis owned 16% of the corporation. He and his co-owners were friends before founding the business. After Bareburger took off, Stavroulakis’ co-owners complained that he was not involved enough to justify his ownership so, as related by Justice Kornreich, they did something rather drastic:

Unbeknownst to him and without his consent, after plaintiff moved to Greece, the defendants, who collectively owned the rest of the Company, transferred all of the Company’s assets to other entities in which defendants (but not plaintiff) have an interest. They did so for no consideration either to plaintiff or the Company, rendering the Company an empty shell.

Stavroulakis sued, alleging claims including breach of fiduciary duty, conversion, and fraudulent conveyance. In Justice Korneich’s decision resolving dueling motions for summary judgment, the court held that “where the defendants are either conflicted or have engaged in corporate waste, they have the burden of establishing entire fairness” of the transaction. The court bluntly ruled that the defendants “have not proffered any justification for their theft,” and awarded plaintiff summary judgment on several of his claims.

While interesting and important in its own right, the substance of the Bareburger decision is less the focus of this article than a tantalizing remark Justice Kornreich made towards the end of her opinion about what the minority could have done to accomplish their goal. Justice Korneich noted that “the defendants clearly wanted a business divorce” from Stavroulakis. The court wrote that “to the extent a majority believes a business would be better off without a problem shareholder, there is legal recourse available to them, such as a buyout or a freeze-out merger.”

To be sure, while the Founders could have sought to effectuate a freeze-out merger to obtain a business divorce from plaintiff, they did not do so. Rather . . . they simply stole all of the Company’s assets by transferring them to other entities for no consideration.

The Freeze-Out Merger

What is a “freeze-out” (a/k/a “cash-out”) merger? It refers to a business combination in which the majority owners cause the entity, through a written agreement or plan of merger, to merge with and into a new entity, with a minority owner of the original entity receiving no ownership interest in the new entity, and his or her ownership interest being extinguished and exchanged for cash.

In a freeze-out merger, the minority owner is involuntarily forced out of the business. So long as the merger complies with statute and any applicable written agreement among the owners, then (with one limited exception discussed below) where a cashed-out minority owner dissents from the merger or liquidation of his or her former interest, he or she has but one exclusive remedy – an appraisal proceeding to determine and get paid the “fair value” of his or her former ownership interest in the business.

The Corporation Merger Statute

The New York appraisal statute, Section 623 of the Business Corporation Law, provides that where the majority shareholders of a corporation vote to merge with another entity, a dissenting minority shareholder may file with the corporation a “notice of his election to dissent” which triggers a series of procedures for the corporation to offer the minority shareholder payment for the shares, and if the dissenter rejects the offer, for either the corporation or the dissenter to institute an appraisal proceeding to litigate the “fair value” of his or her extinguished stock.

The statute provides that, notwithstanding any objection the dissenter has to the merger, once the merger is consummated (usually with the filing of a certificate with the New York State Department of State), “the shareholder shall cease to have any of the rights of a shareholder except to be paid the fair value  of his shares.” Where an appraisal “is available, and merely not exercised,” the shareholder loses any ability to challenge the merger. Norte & Co. v New York and Harlem R. Co., 222 AD2d 357 [1st Dept 1995].

Under BCL 623 (k), there is one very important exception to the exclusive appraisal remedy for corporation mergers:

The enforcement by a shareholder of his right to receive  payment for his shares [in an appraisal proceeding] shall  exclude the enforcement by such shareholder of any other right to which he might otherwise be entitled by virtue of share ownership . . . except . . . such shareholder [may] bring or maintain an appropriate action to obtain relief on the ground that such corporate action will be or is unlawful or fraudulent as to him.

At least two important strands of case law emerge from BCL 623 (k).

First, BCL 623 (k) allows a shareholder who dissents from a corporate merger to bring a lawsuit seeking “equitable relief” – but not money damages – to set aside or rescind the merger as “unlawful or fraudulent” as to him. Breed v Barton, 54 NY2d 82 [1981].

Second, even if a shareholder alleges “unlawfulness” or “fraud,” once the merger is consummated, the shareholder no longer has an ownership interest in the merged entity, extinguishing any standing he or she once had to sue derivatively on behalf of the corporation. Ciullo v Orange and Rockland Util., Inc., 271 AD2d 369 [1st Dept 2000].

The Limited Partnership Merger Statute

When the New York legislature enacted the current limited partnership merger statute, Section 121-1102 of the Partnership Law, the legislative sponsors announced that their intent was to prohibit litigation for “fraud” or “illegality” like under the BCL, thereby giving “greater assurance” to “the validity and, thus, finality of a merger.”

To accomplish this legislative objective, the Partnership Law merger statute still provides the right to “dissent” and seek “fair value,” but intentionally omits any exception for “fraud” or “illegality.” Partnership Law 121-1102 (f) and (g) expressly state that a limited partner who dissents from a merger “shall not become or continue to be a member” in either the merged or successor entity, and “shall not have any right at law or in equity” to “attack the validity of the merger” or have it “set aside or rescinded.”

In Appleton Acquisition, LLC v Natl. Hous. Partnership, 10 NY3d 250 [2008], New York’s highest court held that the limited partnership merger statute bars “any action by limited partners seeking to attack the validity of the merger, including those premised on allegations of fraud or illegality.” The Court clarified “that a limited partner who objects to a merger on these grounds must raise them in an appraisal proceeding.” Therefore, under the Partnership Law, even where a limited partner alleges “fraud,” “illegality,” or seeks “equitable relief” including rescission, his or her “exclusive remedy for challenging the validity of [the] merger [i]s through a statutory appraisal proceeding.”

The Limited Liability Company Merger Statute

Patterned almost verbatim on Partnership Law 121-1102, the operative language of the LLC merger statute, Section 1002 of the Limited Liability Company Law, provides that an LLC member who dissents from a cash-out merger “shall not become or continue to be a member” in either the merged or successor entity, and “shall not have any right at law or in equity” to “attack the validity of the merger” or have it “set aside or rescinded.” Several court decisions already have declared that the consummation of an LLC cash-out merger precludes a dissenting member from attacking the validity of the merger except in an appraisal proceeding.

There is one last, vital feature of cash-out mergers under the LLC Law that should not be ignored. Every court to have considered the issue — most articulately, Justice Kornreich in Slayton v Highline Stages, LLC (46 Misc 3d 450, 451 [Sup Ct NY County 2014]) — has held that Section 407 of the Limited Liability Company Law permits majority owners of an LLC, unless prohibited from doing so by an operating agreement, to consummate a cash-out merger by written consent in lieu of a meeting without prior notice to the minority member. What that means is that the majority can merge and cash-out the minority member’s interest without providing advance notice to the minority member, after which the sole remedy is to seek an appraisal. Powerful stuff if you’re the majority owner of an LLC with no operating agreement.

Conclusion

If done right, the freeze-out merger can be an effective remedy for majority owners faced with a problem minority owner. Under both the LLC and LP merger statutes, where a freeze-out merger is done in accordance with statutory procedures and any written operating / partnership agreement, consummation of the merger should stop litigation in its tracks, except in an appraisal proceeding to determine the fair value of the former owner’s interest in the business. Under the corporation merger statute, the potential for litigation is greater — it can occur (i) in an appraisal proceeding, and (ii) in an equitable action to set aside or rescind the merger as unlawful or fraudulent. Under all three merger statutes — LLC, LP, and corporation — the consummation of the merger should cease all derivative litigation by a former minority owner. In the business divorce arsenal, the freeze-out merger is a mighty weapon indeed.

[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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