Race to the Exit as Professional Practice Falters
February 13, 2017
Does a shareholder have a fiduciary duty not to exercise a contractual right under the shareholders’ agreement to resign and demand a buy-out of his shares by the financially distressed corporation, particularly when the corporation’s default would trigger the other shareholders’ personal guarantees?
That’s the intriguing question posed in an unpublished decision last month by Nassau County Commercial Division Justice Vito M. DeStefano in Mondschein v Badillo, Decision and Order, Index No. 600307/14 [Sup Ct Nassau County Jan. 12, 2017], where a physician resigned from his struggling medical professional corporation amidst ultimately unsuccessful efforts to merge with another practice, and who then brought suit against the P.C., his fellow shareholders, and a related realty company that owned the practice’s medical office, to enforce his buy-out and retirement rights under the various agreements governing the two entities.
The agreements essentially gave senior physician-shareholders the right to retire with an obligatory buy-out by the entities of their equity interests in the practice and the realty, as well as payment of specified retirement benefits. In addition, each shareholder gave a joint-and-several personal guarantee of each other shareholder’s rights to payment.
In 2011, the P.C. was in financial distress and looking to merge its urology practice with a larger practice group. The dispute began in February 2012 when the newest of the P.C.’s four 25% shareholders (not a party to the subsequent lawsuit) announced his resignation, thereby further threatening the practice’s solvency.
Thus began the “race to the exit.” A few days later, the plaintiff gave notice of his intention to retire. A mere three and a half hours later, stating that they disagreed with the legitimacy of plaintiff’s resignation and decrying his “attempt to gain an unfair advantage over his fellow shareholders at a time of financial distress,” the two defendant shareholders submitted their own resignation notices.
The rapid-fire resignations were followed by a standstill agreement which maintained the status quo for about nine months while they continued to negotiate the proposed merger, which ultimately never happened.
In late December 2012, one of the defendants gave notice of a shareholders’ meeting to discuss winding up and dissolving the P.C. The next day, the plaintiff declared his resignation effective as of December 31, 2012.
The practice subsequently ceased operations and the two defendant shareholders eventually joined the practice with which they’d been negotiating the proposed merger. Neither the P.C. nor the realty company dissolved.
The plaintiff’s lawsuit asserted claims against the two entities to enforce the buy-out and retirement agreements and against the two defendant shareholders to enforce their personal guarantees. The defendants’ counterclaims sought judgment declaring the plaintiff’s notice of resignation and retirement invalid, and for breach of fiduciary duty. Prior to any discovery, the plaintiff moved for summary judgment.
Justice DeStefano began his analysis by acknowledging that the plaintiff carried his initial burden on summary judgment by establishing prima facie the entities’ breach of their buy-out and retirement obligations, and the individual defendants’ breach of their guarantees upon the entities’ failure to discharge those obligations.
But that did not end the inquiry based on the defendants’ argument, as related in the decision, that the plaintiff’s notice of resignation “‘was only an attempt to use corporate information [that the practice was in a purportedly precarious financial position] to serve his own interests at the expense of his fellow shareholders’ and that ‘such notice lacked the integrity and fairness required in a transaction between shareholders in a closely held corporation, and is invalid and of no effect.’”
The decision also quoted from the plaintiff’s reply argument, that his “‘motivation and intent with respect to his decision to resign from [the practice] is irrelevant’” under the plain terms of the governing agreements.
In the end, Justice DeStefano agreed with the defendants’ argument and denied summary judgment, holding that the plaintiff’s “motivation and intent in resigning from [the practice] is not irrelevant and, thus, the defendants have raised an issue of fact warranting the denial of plainitff’s motion with respect to defendants’ alleged breach of the shareholders’ agreement.” As he explained:
Here, the shareholders’ agreement expressly provides for a buyout of a shareholder’s shares by the company and that such buyout is guaranteed by those shareholders who remain. [¶] Nevertheless, a shareholder could be in breach of its fiduciary duty to other shareholders, even when exercising an express contractual right.”
In support of his conclusion, Justice DeStefano cited the defendants’ contentions that, at the time he gave notice of his intention to resign, the plaintiff knew that the practice had debts of about $1 million and was in “severe financial distress”; that the prior resignation of the fourth shareholder would exacerbate the practice’s deteriorating financial condition; and that the shareholders were then negotiating a transaction by which they would all resign from the practice and become members of the proposed merger partner.
The Takeaway. No one likes to be left holding the bag, which is why race-to-the-exit scenarios are not unheard of in professional practices which generally require redemption of the shares of a departing shareholder — especially practices with a relatively small number of shareholders such that any departures have an immediate and significant impact on revenues available to fund the buy-outs and any payment of unfunded retirement benefits. Given that the practice in Mondschein apparently was on its knees financially, it stands to reason that the presence of the doctors’ personal guarantees provided the critical catalyst for litigation — something for drafters of shareholder and partnership agreements for professional practices to keep in mind.