The (Even More) Elusive Surcharge in Dissolution Proceedings
November 13, 2017
A year ago I wrote a piece called The Elusive Surcharge in Dissolution Proceedings highlighting the rare appearance in the case law of the surcharge provision found in Section 1104-a (d) of the Business Corporation Law. The provision allows a court in dissolution proceedings brought by an “oppressed” minority shareholder to “order stock valuations be adjusted and may provide for a surcharge upon the directors or those in control of the corporation upon a finding of willful or reckless dissipation or transfer of assets or corporate property without just or adequate compensation therefor.”
If something strikes you amiss, at least as to the provision’s first clause concerning stock valuation, you’re not alone. If the court orders dissolution, there’s no stock valuation to be adjusted, right? The best (if not wholly satisfactory) answer I can give points to subsection “b” of BCL Section 1118, enacted at the same time as Section 1104-a, which allows the court, in determining the fair value of the petitioner’s shares once there has been a buy-out election, to “giv[e] effect to any adjustment or surcharge found to be appropriate in the proceeding under section 1104-a of this chapter.”
To my eye, that’s just sloppy legislative drafting. The stock valuation adjustment and surcharge both feed off the same thing: a transfer of corporate assets without fair consideration. The drafters should have excised the needlessly confusing reference to stock valuation adjustment in Section 1104-a (d), and more simply should have provided in Section 1118 (b) that the court, in determining the fair value of the petitioner’s shares, can “give effect to any surcharge found to be appropriate under section 1104-a (d) of this chapter.” How the surcharge is to be given effect — whether by way of a pro rata distribution to the petitioner of a discrete surcharge amount on top of the fair value award, or by factoring (“adjusting”) it into the business appraisal upon which the fair value award is based — is up to the appraisal experts and ultimately the court. Justice Dianne Renwick’s 2006 decision in the Exterior Delite case gives guidance to that effect.
The legislative sloppiness continues to have real-world consequences, which is why I’m revisiting the subject a year later prompted by a trial court decision earlier this month in Matter of Carter (Ricwarner, Inc.), 2017 NY Slip Op 51479(U) [Sup Ct Bronx County Nov. 2, 2017].
Carter involves a petition for dissolution under Section 1104-a in which the respondent shareholder did not elect under Section 1118 to purchase the petitioners’ shares and the court ultimately ordered dissolution.
Subsequently, the petitioners moved under Section 1104-a (d) for a “downward stock valuation adjustment” of the respondent’s shares — i.e., a diminution of the respondent’s stock percentage and commensurate increase in the petitioners’ percentages — as well as a surcharge against respondent on the ground he “willfully and recklessly dissipated [the corporation’s] assets and failed to distribute proportionate shares of all corporate assets and profits to petitioners.”
As to the requested diminution of the respondent’s stock percentage, the court held that Section 1104-a (d) “does not, as urged by petitioners, authorize a diminution of corporate shares.” To me, that seems like the correct result based on a straightforward reading of the statute’s provision for adjusting stock valuation.
Addressing the surcharge request, however, the decision arguably went off the rails, holding that the surcharge provision in Section 1104-a (d) is available “only when, upon dissolution, the corporation and/or another shareholder seeks to purchase the shares in the corporation held by the proponent of the dissolution as prescribed by BCL § 1118.”
Huh? There’s nothing in the language of Section 1104-a (d) that expressly or impliedly conditions the provision’s surcharge authorization on a buy-out election under Section 1118. Yes, as noted above, Section 1104-a (d) needlessly mentions an adjustment to stock valuation. But needless or not, that clause and the surcharge clause as written are independent of one another. This much was made clear by the Rennert case featured in my post last year — another case in which dissolution was ordered in the absence of a Section 1118 buy-out — in which Justice O. Peter Sherwood confirmed the report of Special Referee Louis Crespo whose thoughtful analysis of the statute concluded, contrary to Carter:
The Referee interprets Section 1104-a [d] to allow for the Court to order an adjustment of stock valuations when the nonpetitioner elects to purchase the movant’s shares at “fair market value” pursuant to BCL “1118” and provide for a surcharge upon the directors or those in control of the corporation upon a finding of willful or reckless dissipation or transfer of assets or corporate property without just or adequate compensation therefor”. The surcharge contemplated under Section 1104-a [d] can be an “adjustment” to stock in an election to “buy-out” at fair market value – which is NOT the case here – as well as any other surcharge where there is no election to buy-out shares and there is misconduct by those in control of the corporation that has had an adverse impact upon the corporation’s value where the Court has directed dissolution – which is the case here, e.g., claim of tax penalty and interest, payment of legal fees, execution of commercial lease after dissolution is ordered.
The court in Carter did not acknowledge Rennert, and the two cases it cited in support of its holding (a) unlike Carter, involved Section 1118 fair value determinations following buy-out elections, and (b) said not a word about a Section 1104-a (d) surcharge. Ironically, Carter did not cite the one case I know about in which a court suggested in dicta that Section 1104-a (d) is inapplicable in the absence of a Section 1118 buy-out — the 2010 decision in Pappas v Fotinos which I wrote about here.
Making matters in Carter, shall we say, even more interesting, after holding Section 1104-a (d) inapplicable the court sua sponte (for non-lawyers, that means on its own accord, without prompting or request by a party) concluded that “petitioners actually seek relief pursuant to BCL § 1111 (c)” which provides:
If the judgment or final order shall provide for a dissolution of the corporation, the court may, in its discretion, provide therein for the distribution of the property of the corporation to those entitled thereto according to their respective rights.
Before reading Carter, I would have thought that a distribution among the shareholders “according to their respective rights” means pro rata based on stock percentages. In support of Carter‘s broader reading, which would allow a departure from stock percentages in making distributions presumably to remedy financial improprieties by a controller, the decision cites a single case authority, In re Seneca Oil Co., an ancient appellate ruling that predates by many decades the enactment of BCL Section 1111 and, at least based on the passage quoted in Carter, doesn’t really address the surcharge issue. Also, if Section 1111 is interpreted as in Carter, doesn’t it render Section 1104-a (d) more or less meaningless?
Whether or not the Carter court correctly interpreted Section 1111, in the end it decided it could not grant relief on the record before it due to the absence of a “complete, accurate and unbiased accounting of the [corporation’s] records” and “where it is alleged that [respondent] has dissipated and looted [the corporation’s] assets, converting the same for his personal use.” The court thus ordered that the books and records of the corporation, which previously was placed in receivership, be reviewed by an independent accountant to prepare a detailed accounting of the corporation’s assets, liabilities, and any use of funds for non-corporate purposes.
In my post on the subject last year, I commented that “the paucity of decisions addressing the statutory surcharge provision in the 26 years since it was added to Sections 1104-a and 1118 likely reflects its limited usefulness.” I also noted the more common and growing alternative practice of pleading derivative claims alongside dissolution in a “hybrid” petition-complaint in lieu of seeking a surcharge under Section 1104-a (d). The conflicting interpretations of the statute in Rennert and Carter, which, let’s face it, derive from the statute’s confused wording, make use of the derivative claim/hybrid approach all the more attractive.