Stock Pledge Agreement Defeats Minority Shareholder’s Standing to Sue for Statutory But Not Common-Law Dissolution
October 01, 2018
Last week, this blog wrote about a decision by Manhattan Commercial Division Justice Saliann Scarpulla in the burgeoning Yu family melee, in that case pitting one brother against the other and their sister over dissolution of two single-asset real estate holding LLCs. In her decision, Justice Scarpulla denied dissolution of the LLCs, despite the plaintiff’s allegations that his brother and sister had a personal “vendetta” against him, which they carried out by amending the operating agreement to remove the plaintiff as a manager, authorizing a mandatory capital, and, when he was unable to meet the capital call, foreclosing on his membership interest.
This week, we look at a companion decision by Justice Scarpulla, issued the same day as the first, expanding the intra-family brouhaha to include the three siblings’ parents. In Matter of Yu v Bong Yu, 2018 NY Slip Op 32009(U) [Sup Ct, NY County Aug. 15, 2018], the court considered the important but novel question of what impact, if any, does a shareholder’s assignment of voting rights under a stock pledge agreement have on his or her standing to sue for statutory dissolution of the business as well as under the common law.
Origins of the Dispute
Moklam Enterprises, Inc. (“Moklam”), a corporation owned entirely by the Yu family, operated various family real estate and business ventures. According to the petition, which you can read here, the origins of the dispute had nothing to do with the business itself. In roughly 2013, after the petitioner, Patrick, and his wife divorced, he and his father, Bong, got into a disagreement over where Patrick should live. For financial reasons, Patrick wanted to sell his home in Scarsdale and move with his children to Manhattan. Bong preferred Patrick remain in his home in Scarsdale. As Justice Scarpulla explained, “Patrick alleges that because he defied his father’s wishes, Bong demanded that Patrick sell his ownership stake in all Yu family entities for approximately $3 million, which, according to Patrick, was 5% of its fair value, to be paid out over 30 years.”
The Alleged Oppression
The corporation had a written shareholders agreement, which Patrick alleged was amended to give him a total stock ownership of 26% of the entity. Patrick petitioned for dissolution based on oppression under Section 1104-a of the Business Corporation Law (the “BCL”) and for common-law dissolution. He alleged that he and his father’s personal disagreement kaleidoscoped into a dozen different kinds of “oppressive actions,” all designed to “force him out of Moklam,” which the court summarized as follows:
(1) demanding that he sell his interest in all family businesses back to the family for a small fraction of their fair value; (2) cutting off all of his legal work from family businesses, which constituted the bulk of his legal practice; (3) cutting off all dividends from Moklam; (4) demanding repayment of more than $600,000 in loans from Moklam after assuring Patrick that he would not have to repay them and not demanding payment for at least four years; (5) improperly demanding repayment of more than $100,000 in wedding and other expenses purportedly lent to Patrick by another family entity more than 10 years earlier; (6) improperly demanding all profits earned by Patrick from the sale of his house; (7) removing him as a managing member from two family business entities in which he had a substantial ownership stake; (8) instituting capital call procedures at these entities and demanding approximately $600,000 in capital contributions from Patrick in retaliation for Patrick’s requests to examine books and records of family entities; (9) filing three lawsuits against him seeking more than $1.3 million; (10) refusing to properly respond to his requests for books and records of the entities in which he is a shareholder despite at least four requests for such information over a 10 month period; (11) refusing to provide access to his own files stored in a building owned by Moklam; and (12) diverting assets from companies partially owned by Patrick to either family businesses in which Patrick has no interest or directly to family members.
The Motion to Dismiss
In response to the petition, Patrick’s family offered “a different account of the family relationship and history,” one which characterized Patrick as perennially down on his luck, the family and its businesses constantly offering him generous financial support when it had no duty to do so, with Moklam loaning Patrick “$900,000 to help him with financial difficulties through the years.” As just one example, the respondents argued that in 2005, Moklam loaned him $600,000 to buy his Scarsdale home, in connection with which Patrick signed a stock pledge agreement, which, as it turned out, became the bane of Patrick’s dissolution petition.
In the stock pledge agreement, which you can read here, Patrick pledged his shares to Moklam as security for Moklam’s loan and was not permitted to exercise any voting rights related to his shares. The key language of the agreement stated:
Throughout the term of this Agreement [Patrick] shall not be entitled to exercise any voting and/or consensual rights and powers relating or pertaining to the [stock] or any part thereof for any purpose. All such voting and other rights and powers relating to the [stock] shall be deemed assigned and transferred by [Patrick] to [Moklam] effective as of the date hereof and shall be vested in and exercisable by [Moklam] at all times throughout the term of this Agreement.
Based upon this language, Patrick’s family moved to dismiss his claim for statutory dissolution under BCL 1104-a, which specifically requires, as an element of standing, that the petitioner be a “holder” of “shares representing twenty percent or more of the votes of all outstanding shares of a corporation.”
The Court’s Decision
In the court’s decision, it noted that while Patrick “repaid the principal, interest, and collection charges on the 2005 loan,” “attorneys’ fees due on th[e] note” are “still in dispute.” “Therefore,” the court held, “Patrick’s Moklam shares remain pledged in accordance with the stock pledge agreement. As per the stock pledge agreement, Patrick is not entitled to exercise any voting rights at this time. As such, he lacks standing to pursue a dissolution of the corporation pursuant to BCL Section 1104-a.”
Despite dismissing Patrick’s statutory dissolution claim, it allowed his claim for common-law dissolution, for which there seemingly is no voting rights requirement, to proceed, ruling, “At this point in the litigation, Patrick’s allegations set forth a reasonable basis to believe that further discovery may reveal further evidence of egregious conduct necessary to sustain the claim for common law dissolution. Accordingly, the claim for common law dissolution will not be dismissed at this time” (citation omitted).
Yu is a reminder of a fundamental requirement of standing in statutory corporate dissolution proceedings – the stock needs to have voting rights. The voting requirement exists under the language of the two mainstay statutes of corporate dissolution – BCL 1104 and 1104-a, as well as the rarely-litigated BCL 1103 (authorizing a petition by the majority of shareholders to dissolve on grounds of insolvency or that dissolution would be “beneficial to the shareholders”).
Yet, until Yu, there were no New York cases addressing the standing of a shareholder who holds voting shares but cannot exercise voting rights under a security agreement. The closest case the majority shareholders were able to cite in their brief in support of dismissal was Matter of TDA Industs., Inc., 240 AD2d 262 [1 st Dept 1997], a case in which the court ruled that an agreement entirely “eliminating” stock voting rights disqualified the stock from being counted towards the 20% threshold to sue under BCL 1104-a. As Patrick argued in his brief in opposition to dismissal, his agreement was different – the stock’s voting rights were not eliminated – his agreement just assigned the right to vote to Moklam (itself unable to vote the shares) until he repaid his loan. In other words, Patrick contended, he remained a “holder” under BCL 1104-a of “shares representing twenty percent or more of the votes” of Moklam. Unfortunately for us commentators, Patrick did not file a notice of appeal, so we may never get an appellate court’s view on the subject.
There are many circumstances in which acquiring nonvoting shares makes good sense for the shareholder, the company, and its controllers. However, if you acquire nonvoting shares, there is all the more reason to consider negotiating buy-sell provisions. Or, if you are pledging shares as collateral security, instead of an assignment of voting rights, perhaps give a proxy or enter into a voting agreement to preserve voting rights under the dissolution statutes. If you do not, under Yu, your only recourse to try to force an exit or buyout from the business through dissolution may be to sue for common-law dissolution, which, unlike BCL 1104-a, does not provide an elective statutory buyout right and, arguably, imposes a more onerous showing of egregious majority misconduct.