Bending the Rules of Standing: The De Facto Merger Doctrine
February 17, 2020
Business Divorce 101: To be entitled to an accounting of a closely-held business, the plaintiff or petitioner must demonstrate the existence of a fiduciary relationship giving rise to a duty to account. Almost always, that requires establishing ownership status in the business — the existence of a general partnership, ownership of shares of stock in a corporation, possession of a membership interest in an LLC, etc.
Can one obtain a judicially-imposed accounting of a closely-held business in which one is not an owner? That was the question decided two weeks ago by a Brooklyn appeals court in Bonanni v Horizons Invs. Corp., 2020 NY Slip Op 00563 [2d Dept Jan. 29, 2020]. The answer may surprise you.
The MRI Business
In 2001, four investors formed MRI Enterprises, LLC (the “Company”) with the following stakes to provide magnetic resonance imaging services to local hospitals:
- 20% – Plaintiff Bonanni, through his wholly-owned corporation, Plaintiff MRI Enterprises, Inc. (“MRI Inc.”)
- 40% – Defendant Fernandez through his wholly-owned corporation, Defendant Horizons Investors Corp. (“Horizons”)
- 20% – Defendant Kalish through his wholly-owned corporation, Defendant Adex Management Corp. (“Adex”)
- 20% – Defendant Hausknecht
To comply with New York law, which prohibits the practice of medicine without a medical license, Hausknecht, a physician, formed Comprehensive Imaging of New York, PLLC (“CINY”), an entity in which Bonanni and MRI Inc. had no membership interest, to provide medical services associated with the Company’s machines.
The Falling Out
For years, Bonanni managed the day-to-day operations of the Company. In 2005, a dispute arose among the members, Kalish assumed Bonanni’s managerial duties, Bonanni was excluded from management, and he ceased to receive membership distributions. Bonanni and MRI Inc., individually and as a member of the Company, sued the remaining members alleging that they froze him out of the business and misappropriated his 20% pro rata share of the LLC’s distributions.
In the ensuing 15-year litigation, Bonanni twice graced the pages of this blog.
In our first post (the first ever published on this blog), Suffolk County Commercial Division Justice Elizabeth H. Emerson dismissed Bonanni’s claim to dissolve the Company, ruling that his allegations of “illegal,” “fraudulent,” and “oppressive” conduct might be enough to dissolve a corporation under Section 1104-a of the Business Corporation Law, but they do not suffice under the more particular, contract-based standard for LLC dissolution found in Section 702 of the Limited Liability Company Law.
In our second post, published nearly a decade after the first, Justice Emerson ruled after a bench trial that Bonanni’s co-members unlawfully froze him out of the Company, converted his 20% membership interest, and misappropriated Bonanni’s 20% profit distributions. The Court awarded money damages and entered judgment accordingly.
The Accounting Holding
In a brief passage in Justice Emerson’s post-trial decision, which you can read here, the Court also granted Bonanni/MRI Inc. a post-trial accounting of CINY, the professional LLC separately formed by Hausknecht, ruling:
The court finds that, as a member of [the Company], MRI Inc. is entitled to an accounting of any and all payments from [the Company] to [Fernandez, Horizons, Kalish, Adex, and Hausknecht] after October 1, 2013, the last day for which information was available at trial. The court also finds that MRI Inc. is entitled to an accounting of any and all payments from CINY, [the Company]’s alter ego and successor-in-interest, to [Fernandez, Horizons, Kalish, Adex, and Hausknecht] for the same period of time.
CINY and Hausknecht appealed Justice Emerson’s ruling requiring CINY to account to Bonanni and MRI Inc., arguing that MRI was “not entitled to an accounting from CINY because MRI Inc. never held a membership interest in CINY.”
On its face, the argument seem compelling. In Jacobs v Cartalemi, the Court held that the “right to an accounting is premised upon the existence of a confidential or fiduciary relationship and a breach of the duty imposed by that relationship respecting property in which the party seeking the accounting has an interest.” For an LLC, that means membership status, a contractual right to an accounting under an operating agreement, or both.
But lawyers love to find exceptions to hard and fast rules. Enter the de facto merger doctrine. The appeals court started with a basic premise: “Generally, a corporation which acquires the assets of another is not liable for the torts of its predecessor.” But, the Court continued:
[S]uch liability may arise if . . . there was a consolidation or merger of seller and purchaser, the purchaser corporation was a mere continuation of the seller corporation, or the transaction was entered into fraudulently to escape such obligations. Accordingly, a transaction structured as a purchase of assets may be deemed to fall within this exception as a de facto merger. [Citations omitted.]
The court identified four “hallmarks of a de facto merger”:
- continuity of ownership
- cessation of ordinary business and dissolution of the predecessor entity
- assumption by the successor entity of the liabilities ordinarily necessary for the uninterrupted continuation of the acquired entity’s business; and
- continuity of management, personnel, physical location, assets, and general business operation.
Applying these factors, the court concluded:
[I]n early 2012, [the Company]’s assets and employees were transferred to CINY, [the Company]’s business ceased, and CINY provided the services to the client hospitals that MRI LLC had previously performed. The equipment, assets, business operation, management, and some of the personnel remained unchanged. The forensic accountant who testified on behalf of the plaintiffs identified numerous transactions that were ‘questionable’ or ‘highly unusual,’ and others that were indicative of self-dealing. Most notably, [the Company] transferred an MRI scanner to CINY at a price significantly less than its fair market value. Accordingly, the Supreme Court’s conclusion that in late 2012/early 2013 there was a de facto merger between [the Company] and CINY was supported by the record. Therefore, MRI Inc. was entitled to an accounting from CINY.
Room for Future Litigation
The de facto merger doctrine — like its cousin, the doctrine of veil piercing — is commonly used by a plaintiff to attempt to obtain a money judgment against an entity or individual owner closely related to the primary wrongdoer. Bonanni appears to be the first New York appellate decision to grant the non-monetary equitable remedy of an accounting against an entity in which the plaintiff lacked an ownership interest or fiduciary relationship based upon the de facto merger doctrine. It will be interesting to see if future litigants rely upon Bonanni to expand the de facto merger doctrine in business divorce cases to other kinds of non-monetary remedies, such as injunctive or declaratory remedies against the successor entity.
Another interesting feature of Bonanni – CINY was not a money judgment debtor. Article 52 of the New York Civil Practice Law and Rules governs enforcement of money judgments. It authorizes post-judgment asset discovery, including the issuance of subpoenas to third-parties who may have received assets transferred from a judgment debtor. By granting Bonanni and MRI Inc. an accounting of transactions involving a third-party transferee, the Court in effect ordered an accelerated form of post-judgment asset discovery. Perhaps other courts may eventually follow Bonnani’s lead and order similar relief in the business divorce context.