Then There Were Two: Court Rejects Minority Shareholder’s Claim of Wrongful Termination Under Founders Agreement

June 19, 2017

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2of3 A company has four founding shareholders each of whom is a director-employee. Their agreement provides that the votes of three out of four founders are required to terminate the employment of any founder or to approve a series of other major decisions such as making distributions, issuing or redeeming shares, amending the certificate of incorporation or bylaws, etc.

When one of the founders no longer is employed and thereby automatically loses his seat on the Board, under the same provision the number of votes required to approve termination of another founder or the other enumerated major decisions drops to two out of three.

Sounds simple so far, right?

Now let’s complicate things. Under another provision, any amendment of the agreement requires the approval of the company and of the founders holding at least 75% of the voting shares, which raises the following questions:

What happens when only three founders remain, two of them vote to terminate the third, and the remaining two hold less than 75% of the voting shares?
Can the business be managed with less than three founders who lack the voting power to amend the agreement to allow the them to make the enumerated major decisions?
Is the vote to terminate the third founder invalid absent a concurrent amendment of the agreement authorizing management of the company by only two founders?
If so, does that render the two-out-of-three voting authorization meaningless?

Those were the critical issues addressed in a noteworthy decision last month by Manhattan Commercial Division Justice Anil C. Singh (subsequently named an Associate Justice of the Appellate Division, First Department) in Simon v Kyrejko, 2017 NY Slip Op 31155(U) [Sup Ct NY County May 30, 2017], involving a dispute among the founding shareholders of a pair of affiliated companies that own and operate a Brooklyn-based vodka distillery known as the Industry City Distillery.

According to the plaintiff’s amended complaint, in 2012 he and three others entered into substantially identical Founders Agreements for two companies, one to operate the vodka distillery and the other to hold the intellectual property.

The distillery and vodka sales got off to a good start, but within a year the two defendant founders allegedly commenced a “power-grabbing scheme” in which, first, in late 2013, they forced out one of the four founders and, second, in 2014, they held a Board meeting unattended by the plaintiff at which they voted to terminate the plaintiff’s employment and remove him from the Board. The two defendant founders also subsequently demanded the redemption of the plaintiff’s unvested shares.

The plaintiff sued on a variety of claims, including one alleging that the defendants breached the Founders Agreements and their implied duty of good faith and fair dealing by terminating plaintiff’s employment without cause, and that all of their subsequent actions were ultra vires in the absence of the approval of three founders.

The plaintiff eventually moved for partial summary judgment, arguing that, notwithstanding the agreements’ express authorization for a vote by two of three founders to terminate a founder’s employment, any such action required the contemporaneous amendment of the agreements by 75% approval, and that the two provisions “must be read together to preclude running the business with less than three founders.”

The argument did not fly with Justice Singh who found nothing in the agreements explicitly supporting plaintiff’s contention that the companies are “always required” to be managed by at least three founders. Justice Singh also found plaintiff’s contention “debunked” by deposition testimony of the agreements’ attorney-drafter to the effect that, at the time the agreements were discussed and finalized, and even though in his opinion the agreements “should be amended” when two founders terminate the third, the four founders simply did not contemplate how the business would be managed when only two founders remained.

Justice Singh also found that construing the section of the agreements governing amendments to require at least three founders to run the business “contradicts the plain language” of the section authorizing founder termination by two of three votes, and also would violate rules of contract construction forbidding a court from inserting new terms “under the guise of construction” or reforming an agreement without the parties’ assent to reformation.

The court’s denial of the plaintiff’s summary judgment motion leaves unresolved the bulk of the plaintiff’s claims for breach of fiduciary duty, fraud, defamation, tortious interference with contract, and others. So it looks like the case is headed to an eventual trial.

There seems to be little question that the founders wittingly or more likely unwittingly painted themselves into a corner by adopting agreements that fail to address the consequences of terminating two of the four founders, particularly given their business model and likely need to raise funds from outside investors.

In this respect the case reminds me of Gerlanc v Beatrice about which I recently posted, also involving a dispute between minority and majority owners of a start-up distillery (bourbon, not vodka) located in the New York metro area, in which the owners’ failure to adopt a written agreement at the outset seriously hobbled the company’s business plans once there was a falling out. If we substitute vodka for bourbon, the following advice offered by Vice Chancellor Laster to the parties in Gerlanc applies with equal force in the Simon case:

And maybe what people ought to do is say, “Wow, there’s mutual risk here, and what we really want to do is make good [vodka]. So let’s figure out some protective provisions for the minority that lets us go forward and make good [vodka].” And that, I think, would actually be a good outcome and a better use of people’s time than litigation.