Business Judgment Rule Prevails in Fight Over Liquidation Plan for Dissolved Madoff Feeder Fund
June 29, 2020
FGLS Equity LLC was one of many feeder funds caught up in the maelstrom that followed the exposure and meltdown in 2008 of the Bernie Madoff Ponzi scheme. It lost virtually all of its money in its account with Bernard L. Madoff Investment Securities (BLMIS). Eventually, Irving Picard, the Trustee appointed by the Bankruptcy Court to oversee BLMIS’s liquidation, allowed and paid FGLS’s claim in the much-reduced sum of $3.45 million based on the “net investment method” which ignored all fictitious profits. Mr. Picard also disallowed any credit for the $3.15 million that in 2002 was “rolled over” into FGLS from a predecessor feeder fund called C&P Associates.
The founder and manager of FGLS and C&P, and the direct conduit to Bernie Madoff and BLMIS, was Steven Mendelow. In 2010, Mr. Picard sued Mr. Mendelow and his wife to recover over $14 million in allegedly fraudulent transfers to them from BLMIS. In 2018, after Mr. and Mrs. Mendelow both died, Mr. Picard recovered almost $10 million from their estates in settlement of the fraud claims. The settlement contained a “no admission of liability” provision.
The resolution of FGLS’s claims in Bankruptcy Court and the deaths of the Mendelows closed one litigation chapter but laid the groundwork for another. Last month, the second chapter culminated with a first impression decision by Manhattan Commercial Division Justice Joel M. Cohen, who was tasked with deciding whether to approve a plan of liquidation proposed by a member-appointed liquidator under an important but untested statute, Section 703 of New York’s LLC Law, over the fierce objections of a number of FGLS members. The case is Matter of FGLS Equity LLC, 2020 WL 2557877, 2020 NY Slip Op 31476(U) [Sup Ct NY County May 20, 2020].
FGLS’s Dissolution and Plan of Liquidation
Under Section 10.1 of FGLS’s operating agreement, the deaths of the Mendelows — both were designated as FGLS’s managers even though Mr. Mendelow exercised primary if not exclusive control of the company during his lifetime — automatically triggered the dissolution and liquidation of FGLS by a person to be elected by a majority in interest of the fund’s investor members. The members elected one of the members, an accountant named Steven Turchin, as liquidator and managing member. [Full Disclosure: I served as consultant to Mr. Turchin’s counsel at Yeskoo, Hogan & Tamlyn.]
Article 10 says little about the liquidator’s duties or the liquidation process. It merely provides for distributions to be made in proportion to the members’ adjusted capital accounts; that no member is liable to repay the negative amount of his or her capital account; that the members are to be provided with an accountant-reviewed statement of assets and liabilities upon liquidation; and that articles of dissolution are to be filed upon completion of the liquidation.
In late 2018, Mr. Turchin presented the members with a plan of liquidation and distribution of the recovered proceeds. The plan used the same net investment method used by Mr. Picard, whereby only those members with positive capital accounts, i.e., who invested more than they took out (excluding the rollover transfers), participated in the recovery at the rate of 48% of their account balances. Of the 41 members, 17 had positive accounts ranging from $10,000 to almost $1 million, and 24 had negative accounts within a lesser range. One of the positive accounts belonged to the Mendelow Family Foundation.
Mr. Turchin’s liquidation plan acknowledged FGLS had colorable claims against the Mendelow Estates and their attorneys but recommended against pursuing them for a number of reasons including potential statute-of-limitations and lack-of-standing defenses. Other reasons were Mr. Picard’s potential right as assignee to lay claim to any recovery against the Mendelow Estates; the possibility that FGLS would have to advance the Mendelow Estates their attorneys’ fees under the operating agreement’s indemnification provisions; and the expense and delay entailed by any litigation.
After seeking member approval of his plan, Mr. Turchin reported that members holding a significant portion of FGLS’s positive capital had objected to his decision not to sue the Mendelow parties, as well as his decision to make a distribution to the Mendelow Family Foundation. As to the proposed Mendelow litigation decision, Mr. Turchin stated he was open to allowing members who wished to sue on behalf of FGLS to do so on condition that some or all of such members’ distributions due them would be escrowed to fund the lawsuit and indemnify FGLS against any expenses.
Mr. Turchin Petitions for Plan Approval
In July 2019, Mr. Turchin filed a petition in Manhattan Supreme Court seeking approval of his plan of liquidation under LLC Law § 703 (a) which provides:
In the event of a dissolution of a limited liability company, except for a [judicial] dissolution pursuant to section seven hundred two of this article, unless otherwise provided in the operating agreement, the members may wind up the limited liability company’s affairs. Upon cause shown, the supreme court in the judicial district in which the office of the limited liability company is located may wind up the limited liability company’s affairs upon application of any member, or his or her legal representative or assignee, and in connection therewith may appoint a receiver or liquidating trustee.
The petition identified objections made by some of the members, focusing primarily on Mr. Turchin’s decision to forgo litigation against the Mendelow parties and to allow the Mendelow Family Foundation to participate in distributions from FGLS.
The Objectors filed an answer with counterclaims seeking declarations that Mr. Turchin’s decision to forgo litigation against the Mendelow parties is not protected by the Business Judgment Rule (BJR), disallowing any distribution to the Mendelow Family Foundation, and setting forth proposed claims to be brought against the Mendelow parties. The Objectors also sought an order giving the members rather than Mr. Turchin the right to decide by majority vote whether to file a direct action against the Mendelow parties.
The Court Addresses Its Powers Under § 703 (a)
As best as I can tell, the FGLS case may be the first and only New York case thus far in which a court has been asked to pass judgment on an LLC plan of liquidation proposed not by a court-appointed liquidating trustee (a/k/a permanent receiver) exercising court-specified powers as an officer of the court, but by a liquidator appointed by the LLC’s members as mandated by the operating agreement’s provision governing non-judicial dissolution.
In his decision, Justice Cohen observed that § 703 (a) “does not define the precise extent of the Court’s powers, but the Court is free to ‘fashion remedies to speak to the omissions in the LLC statute,’” citing the Tzolis case in which the Court of Appeals found a common-law right of LLC members to sue derivatively. Justice Cohen then bolstered his pitch for the court’s equitable powers, writing:
The court may thus resort to common law and equitable remedies not specifically enumerated by the statutory language. It also may look to analogous sections of the Business Corporation Law (BCL) for guidance. In this connection, BCL § 1008 (a) is of some relevance, providing that the Court “may make all such orders as it may deem proper in all matters in connection with the dissolution or the winding up of the affairs of the corporation.” Accordingly, this Court determines that it has jurisdiction to consider and resolve the issues raised by the Petition and the Objectors. [Citations omitted.]
The Court Upholds Mr. Turchin’s Plan of Liquidation Under the BJR
Mr. Turchin’s and the Objectors’ briefs both framed the issue similarly, as whether Mr. Turchin’s determination not to commence litigation against the Mendelow parties, and the Mendelow Family Foundation’s participation in distributions, was immune from judicial second-guessing under the BJR.
On the threshold question of burden of proof, Justice Cohen rejected the Objectors’ contention that Mr. Turchin “bears the burden of proffering evidence that the business judgment rule is applicable.” Rather, the court wrote, “the party challenging the company’s decision must make an affirmative showing of bad faith, self-dealing, discrimination, breach of fiduciary duty, or other misconduct.”
The Objectors submitted deposition testimony from prior litigations and other documents in an effort to establish that Mr. Turchin’s determinations were not protected by the BJR due to his alleged “conflicts of interest and bad faith” stemming from the period he worked for the accounting firm (K&W) with which Mendelow was affiliated, whose principal (Paul Konigsberg) was criminally charged and pled guilty, and which ultimately collapsed due to its involvement with Madoff’s Ponzi scheme. “Turchin’s deep and long-term professional connection to Steven Mendelow,” Objectors wrote, “precludes him from objectively determining whether suit should be filed against the Estates of Steven and Nancy Mendelows, their heirs, and related entities.”
In response, Mr. Turchin denied that he had “a deep or long-term professional relationship with Steven Mendelow” and averred he was unaware of any improper relationship between K&W and BLMIS or knew that BLMIS was a Ponzi scheme.
Justice Cohen concluded, “[b]ased on a review of the entire record,” that “the Objectors have failed to meet their burden to rebut the presumption in favor of the business judgment rule.” As he further explained:
[Objectors’] own evidence confirms that Madoff’s Ponzi scheme was a closely-guarded secret within the firm known only by the Konigsbergs and Mendelow, and at best was only the subject of suspicion to other employees at K&W. There is no support in the record for their implication that Turchin was aware of the misconduct, much less that he actively participated in it. Rather, the evidence supports Turchin’s account that he was merely one of many low-level staff accountants with an adversarial relationship with Mendelow and limited involvement servicing K&W’s BLMIS accounts. The Objectors’ reliance on cases in which the protection of the business judgment rule was denied in view of conflicts arising from close business and personal ties between corporate officers and directors is, thus, misplaced The Objectors’ assertion that Turchin had a deep personal relationship with Mendelow is pure speculation, which is insufficient to support a claim for breach of fiduciary duty. The Objectors’ insistence that Turchin lacks impartiality because he ignored a “blizzard of red flags” at K&W is also not supported by the record. [Citations omitted.]
Besides BJR protection, Justice Cohen also held that under LLC Law § 409 (b), Mr. Turchin as a non-lawyer was entitled to rely on the professional advice of his legal counsel as to the merits of the proposed claims against the Mendelow parties and the feasibility of pursuing them. Apart from the uncertainty of prevailing on the merits of such claims, Justice Cohen wrote, “there is a reasonable basis for [Mr. Turchin] to conclude, in the exercise of business judgment, that any litigation could delay a distribution to the members for years, and that the attendant attorneys’ fees could completely deplete the funds available.”
Finally, Justice Cohen also rejected the Objectors’ request to refer to the members the decision to pursue litigation against the Mendelow parties, among other reasons, because it would contravene Section 5.4 (C) of FGLS’s operating agreement which vests the power to commence litigation in the managing member.
The Takeaway. The BJR serves to foster self-governance of business entities by shielding from judicial second-guessing the actions of fiduciaries made in good faith and in the honest belief that the action taken is in the best interests of the company. Justice Cohen’s decision in FGLS, applying the BJR to uphold the liquidator’s plan of dissolution, is an important contribution to our understanding of the courts’ role under LLC Law § 703 in resolving disputes over the actions of liquidators appointed by the members in accordance with the operating agreement.