Never the Twain Shall Meet: Damages Claims Do Not Offset the Purchase Price in Buy-Sell Agreements
August 22, 2022
Nestled between Broadway and Church Street in New York City’s hottest neighborhood is the landmarked, stone-façade building at 66-68 Reade Street. Now marketed as the superluxury boutique condominium complex 66 Reade, the historic building and its cast iron columns evoke the most stately parts of New York City’s architectural polish.
The conversion of 66 Reade to luxury condominiums was the product of a 15-year partnership between Jean Hieber, the owner of the property, and Fred Taverna, Hieber’s property manager and a trusted advisor. After years of apparent cooperation, fissures emerged in the parties’ relationship as they approached the finish line. Ultimately, the parties commenced dueling lawsuits against one another, each side hurling a bevy of claims and defenses at the other, and Business Divorce aficionados took notice.
As units in the building were marketed in the high seven-figures, the first round of the contentious dispute behind the project concluded with Manhattan Commercial Division Justice Borrok dismissing Hieber’s claims to specifically enforce a compelled sale of Taverna’s 25% interest in the project for $40. Hieber Reade Street LLC v Taverna, Index No. 655454/2021 (NY County 2022) offers well-reasoned guidance on the conceptual separateness between claims to specifically enforce a buy-sell agreement, on the one hand, and damages claims, on the other.
HRS and the Operating Agreement
In 2005, Jean Hieber and Fred Taverna formed Hieber Reade Street LLC (the “Company” or “HRS”). According to the Operating Agreement, Hieber contributed the Property to HRS and Taverna agreed to manage and develop the Property into a condominium complex with two additional floors that would be invisible from the ground, to maintain the building’s historic façade. Hieber held 75% of the membership interests in HRS, and Taverna held 25%.
The parties anticipated that additional funds would be needed to complete the planned conversion of the Property, and HRS’s Operating Agreement therefore gave Hieber, as the majority member, the power to make capital calls by written notice, which required Taverna to contribute his proportional share. Under the Operating Agreement, if Taverna failed to pay his share in response to a capital call, any contributions by Hieber would be booked as loans to the Company rather than capital contributions. Taverna had no power to make capital calls.
The Operating Agreement further provided that if Taverna failed to contribute his portion of a capital call, he could be involuntarily bought out for the balance of his capital account:
If Taverna (a) defaults in making any additional contribution required of him under Section 4.02 and such default shall continue for twenty (20) days after notice thereof . . . then upon happening of any such conditions Members constituting a Majority in Interest shall have the right, exercisable within one hundred twenty days of the occurrence of the condition giving rise to this right of election, may by notice to Taverna or his legal representative purchase Tavern’s [sic] membership interest in the Company for a price equal to the total of (i) the balance of his Memorandum Account and (ii) any Accrued Preferred Return thereon.
$10 Million of “Informal” Capital Contributions
From 2005 to 2019, Taverna managed the Property in its conversion to condominium units. Over the years, both Hieber and Taverna made additional contributions to the Company, but none in strict compliance with the capital call provision of the Operating Agreement. Rather, Taverna requested additional funds when the project required, and he and Hieber made contributions that were not proportional; Hieber paid more than her 75% share of the total contributions.
Additionally, despite the language in the Operating Agreement stating that any excess contributions that Hieber made over her proportional share of Taverna’s contribution would be treated as loans, the parties counted Taverna’s apparent shortfall in contributions against his capital account.
All told, according to Hieber, between 2005 and 2019, Hieber (or her successor entities) contributed $8.28 million to the Company, and Taverna contributed approximately $2 million, resulting in a shortfall by Taverna of almost $900,000. Since the $2 million represented the entirety of Taverna’s cash contribution, that was the balance of his capital account as of 2020.
The Falling Out, Catch-Up Notice, and $40 Sale
In January of 2020, Hieber’s daughters (who had taken over management of Hieber’s interests) terminated Taverna from his management authority within HRS. Several months later, they sent a letter to Taverna: (i) making an additional capital call of $100,000, of which Taverna was required to contribute his $25,000 portion within 15 days, and (ii) demanding that Taverna “become fully caught up in [his] delinquent capital contributions”—i.e., pay approximately $900,000 to restore the 75%/25% ratio in all contributions between 2005 and 2020.
When Taverna failed to make the demanded payment, the Hiebers sent notice that they were exercising their option to purchase Taverna’s interest in HRS. Pursuant to Section 8 of the Operating Agreement, the buyout price should have been the balance of Taverna’s capital account—approximately $2 million. But the Hiebers found other alleged malfeasance. According to the later-filed Complaint, the Hiebers uncovered claims against Taverna arising from Taverna’s alleged self-dealing in retaining contractors in which he had an interest and allegedly fraudulently inducing the Hiebers to take out a $4.4 million loan in 2019.
Accordingly, the Hiebers’ notice of their exercise of their option to purchase Taverna’s interest indicated that they would offset the buyout price with the minimum value of the alleged misconduct that they uncovered: “While Section 8.01 of the Operating Agreement provides for a purchase price . . . the minimum damages—the full extent of which is not yet known but is no less than $12 million—caused by the acts of bad faith, dishonesty, and illegality . . . far exceed that purchase price, thus obviating any entitlement to payment for [Taverna’s interest].”
When Taverna failed to appear at the closing that the Hiebers scheduled, the Hiebers sent Taverna a letter attaching four checks totaling $40 and declaring the sale of Taverna’s interest in HRS to the Hiebers closed.
Damages Claims Cannot Offset the Purchase Price Under the Buy-Sell Provision
When Taverna disputed that his membership interest in HRS was sold, the Hiebers commenced an action seeking a declaratory judgment that Taverna’s interests had properly been bought out pursuant to Section 8 of the Operating Agreement. The Complaint also pled causes of action for the alleged acts of Taverna’s self-dealing, fraudulent inducement, and other malfeasance in connection with his management of the Property and its conversion.
Taverna moved to dismiss the Complaint. As to the claims seeking to enforce the sale of his interest, he argued that the sale was improper to the extent it was based on the alleged $900,000 shortfall that Taverna accrued between 2005 and 2019 Taverna argued that although there were “informal contributions” in 2005-2020, there were no capital calls that followed the procedures of the Operating Agreement, so the Hiebers could not demand that Taverna catch up.
Justice Borrok dismissed the Hiebers’ claim for a declaratory judgment seeking to enforce the sale. The Court found that by failing to pay Taverna the value of his capital account (approximately $2 million), the Hiebers’ attempted purchase of Taverna’s interest did not comply with the Operating Agreement and would not be enforced:
[I]n the August Letter, the plaintiffs indicate that the defendants had a capital account of $2 million and were approximately $900,000 deficient – i.e., they were supposed to have a capital account $2,942,856.60. When the plaintiffs exercised their option to buy the defendants out based on the $25,000 capital call in August 2020, which they did not make, the plaintiffs only paid the defendants $40. This simply does not comply with the mechanism set forth in Section 8.01 of the Operating Agreement for buying Mr. Taverna out.
In other words, the Hiebers could not offset the purchase price with the value of their claims against Taverna for alleged mismanagement:
The plaintiffs simply can not oust him without paying his memorandum account balance (i.e., $2 million) and then claim that he merely has a breach of contract claim. This is not the deal the parties struck.
Accordingly, Taverna is still a member of HRS. The Court also dismissed any claims predicated on conduct that the Hiebers had knowledge of predating six-years prior to the commencement of the action. Otherwise, however, the Court refused to dismiss the Hiebers’ complaint, finding that they had well-pled claims against Taverna for fraudulent inducement and breach of fiduciary duty arising from his alleged malfeasance while managing the Property.
Specified-Value Buy-Sell Agreements and Damages Claims
Several months ago, I wrote about a case considering the intersection of damages claims between owners of a closely held-business and one owner’s efforts to enforce the mandatory buy-sell provision of the company’s shareholders’ agreement. In Estate of Connie Collins v. Tabs Motors of Valley Stream Corp., No. 160529/2019 (NY County 2021) a shareholder sought specific performance of the buy-sell provision against certain shareholders who had triggered the provision, and the triggering shareholders sought to prevent specific performance of the sale by citing their breach of fiduciary duty claims against their adversary-shareholder. In that case, Justice Reed determined that the terms of the buy-sell provision could be enforced separate from the damages claims: “Furthermore, even if the [breach of fiduciary duty] claims were true,” held the Court, “they would not invalidate the buy-sell provision. The buy-sell provision is still enforceable.”
Hieber Reade Street LLC v Taverna highlights the same interplay. Whether the Hiebers have strong damages claims against Taverna, they could not offset the sale price called for by the Operating Agreement with those claims. Like the Court’s ruling in Tabs Motors, the damages claims—meritorious or not—do not affect the enforceability or terms of the buy-sell provision in the Operating Agreement. Counsel seeking to enforce a buy-sell agreement while at the same time prosecute (or defend against) claims for breach of fiduciary duty (or other damages claims) would be wise to take notice.
What Lies Ahead for HRS?
Now that the Hiebers’ claims to specifically enforce the sale of Taverna’s interest are dismissed, what remains of the alleged $900,000 shortfall in capital contributions? Justice Borrok did not dismiss the Hiebers’ claims for breach of contract arising from that alleged shortfall, but the Court in a footnote expressed its doubts:
It is undisputed that the plaintiffs were aware of the defendants’ shortfall in funding contributions dating back to 2005. To the extent that they actually tried to assert a shortfall not merely based on the new capital call of $25,000 but all deficiencies during the entire 15-year period to which he was given notice and an opportunity to cure, there is an issue as to whether this was pretextual and whether the right to demand a true-up (i.e., cure) was waived as to prior capital calls. The plaintiffs may well have been dissatisfied with Mr. Taverna for all the reasons that they allege, but they never demanded Mr. Taverna “pay up” or be bought out before.
We’ll see if future proceedings in this case bring the issue to the forefront, though based on the above language, it is not hard to imagine that Taverna feels like he has the upper hand in the Hiebers’ bid to recover the $900,000 that Taverna allegedly under-contributed over the years.
Another interesting development: since the decision, the Hiebers have sought to revoke their exercise of their buyout option, stating in an August 12 letter that they “are not in position to pay [Taverna his] memorandum account balance at this time.” Is that revocation enforceable? Not under the guidance of Walsh v White House Post, a Delaware case where an LLC exercised its purchase rights in the Operating Agreement, then sought to walk it back. If Taverna is willing to be bought out for $2 million, the Court’s decision may have put him in the catbird seat.