Who Is a “Control” Person for Purposes of the Dissolution Statute’s Surcharge Provision?

March 16, 2020

Section 1104-a of the Business Corporation Law (the BCL) empowers courts to dissolve a corporation if the petitioning shareholder can establish either of two specified grounds for dissolution. Section 1104-a(a)(1) authorizes dissolution upon a showing of ” illegal, fraudulent or oppressive actions toward the complaining shareholders” by the “directors or those in control of the corporation” (emphasis added). Section 1104-a(a)(2) authorizes dissolution upon a showing that property or assets of the corporation are being “looted, wasted, or diverted for non-corporate purposes” by the “directors, officers or those in control of the corporation” (emphasis added).

At the end of the statute, the so-called “surcharge” provision, section 1104-a(d), empowers courts to “order stock valuations be adjusted” and to “provide for a surcharge upon the directors or those in control of the corporation upon a finding of wilful or reckless dissipation or transfer of assets or corporate property without just or adequate compensation” (emphasis added).

As noted with italics above, all three statutes contain an identical three-word phrase allowing courts to dissolve based upon conduct committed by, and/or impose a surcharge against, “those in control” of the corporation. What does it mean to be “in control?” As noted in a prior post, reported decisions involving a corporate dissolution petitioner seeking a surcharge against the respondent are exceedingly rare. Cases in which corporate dissolution petitioners obtain a surcharge are unicorn-like in their rarity – there is only a single case of which we are aware.

With the scarcity of case law on the subject of surcharges, a recent decision caught our eye, in which a court, apparently for the first time, considered what it means to be “in control” of the corporation for purposes of imposing a surcharge.

In Matter of Telano, Decision and Order [Sup Ct NY County Jan. 8, 2020], Manhattan Justice Joseph Risi tackled the interesting question of whether a shareholder petitioning for dissolution may sue a non-shareholder, director, or officer under the “surcharge” provision of section 1104-a(d) seeking in effect to use the statute as a substitute for an otherwise viable cause of action.

The Corporation and its Shareholders

In 2008, Eagle Security Group, Inc. (Eagle) was formed for the purpose of marketing and selling security portals at airports and high-security facilities. The founders, according to the amended petition, were Telano and Monfredo. Needing the acumen of an experienced businessperson to help manage the fledgling venture, they brought aboard Brucculeri, to whom they conveyed a majority of Eagle’s stock. In 2010, they entered into a written shareholders agreement. Under Article 2.1, stock ownership was held 62% Brucculeri, 25% Monfredo, 6.5% Telano, and 6.5% Kyriacou.

Bradlau and Tone’s Legal Representation

In early 2010, Eagle hired the law firm of George F. Bradlau & Associates, PLLC to assist with the company’s corporate legal work. Two lawyers, Bradlau and Tone, provided various services to Eagle, including drafting the shareholders agreement and by-laws, attending quarterly board meetings, preparing corporate minutes, responding to requests for legal advice from Eagle and its board, and drafting legal documents and correspondence.

The Petition

In 2018, Telano and Monfredo sued their co-shareholders for judicial dissolution under section 1104-a(a)(1) and (2) and an accounting. As part of their judicial dissolution cause of action, they demanded an “order pursuant to Section 1104-a(d) . . . adjusting the stock valuations for Eagle and providing a surcharge upon the directors or those in control of the corporation, other than Kyriacou, due to their willful and reckless dissipation and transfer of assets and corporate property without just or adequate compensation therefor.”

In addition to suing Eagle’s shareholders, Telano and Monfredo named as “additional party respondents” Eagle’s outside law firm and accountant, though they did not allege any specific causes of action against them. Telano and Monfredo sued in their own individual capacities, not derivatively as shareholders of Eagle.

The amended petition’s allegations about Bradlau and Tone consisted of just a few short paragraphs. “Bradlau, along with Respondent Tone,” the petition alleged, “are attorneys who served as general counsel to Eagle, though they are not shareholders of the corporation,” and they “continue to serve as general counsel to Eagle.”

“Bradlau and Tone,” it continued, “were instrumental in setting up competing business ventures that were wrongly, and intentionally funneled business belonging to Eagle.” According to the petitioners, the “respondents” collectively “have all conspired together to surreptitiously set up a competing business venture or ventures to that of Eagle,” “conspired together to fraudulently divert . . . profits,” and “conspired to falsify Eagle’s financial records, so they could conceal the fact that such profits were diverted.”

The Dismissal Motion

Bradlau and Tone filed a motion to dismiss, pointing in their memorandum of law to Articles II and III of the shareholders agreement they drafted to show that they were not at any time directors, officers, or “in control” of Eagle and could not be subject to a surcharge. They also moved to dismiss the accounting claim, arguing that they lacked an ongoing fiduciary relationship with Eagle, attaching a copy of a termination letter they sent Eagle withdrawing as counsel effective December 27, 2013.

In opposition to Bradlau and Tone’s dismissal motion, Monfredo filed an affidavit in which he devised a new legal theory not referenced in the petition. According to Monfredo, when Brucculeri first introduced him to Bradlau, Bradlau was considered a “possible investor in the company,” not the company’s attorney. Pointing to Eagle’s payment of over $400,000 of what Monfredo implied were suspicious or inflated legal fees, Monfredo alleged that “it is my belief” that Bradlau was “not just Eagle’s attorney, but, in fact, a silent investor who was siphoning [with Tone] large sums of cash from the company.”

In their reply memorandum of law, Bradlau and Tone argued that Telano and Monfredo “have not cited to even one case to support their contention that a ‘silent investor’ is deemed to be ‘in control’ of a corporation for purposes of BCL 1104-a,” and “our research has failed to uncover even one case where outside lawyers, who were paid for legal services provided to a corporation, were deemed to be ‘in control’ of a corporation so as to be a proper party to a corporate dissolution proceeding.”

The Decision and Order

In his decision, Justice Risi noted that the “corporation’s governing documents identify certain individuals as shareholders, directors and corporate officers, but do not name Bradlau or Tone in any capacity whatsoever,” and the “petition explicitly acknowledges that Bradlau and Tone are not Eagle shareholders.” Nonetheless, the court noted that Monfredo’s opposing affidavit “claims, among other things, that he believes that Bradlau was a silent investor who siphoned large sums of cash from Eagle, along with Tone,” rendering them “a party in control of the corporation, for the purposes of BCL 1104-a.” Nonetheless, the court concluded:

Here, the petition and the documentary evidence establishes that Bradlau and Tone are not shareholders, officers, director, or employees of Eagle. . .

The petition does not allege that either Bradlau or Tone were ‘in control of’ Eagle. To the extent that Monfredo in his opposing affidavit claims that Bradlau and Tone were silent investors and were ‘in control’ of Eagle, so as to permit a surcharge against them pursuant to Business Corporation Law 1104-a(d), said assertion constitutes an improper attempt to amend the petition. Moreover, these claims are clearly based upon Monfredo’s personal beliefs, are wholly unsubstantiated and state nothing more than bare legal conclusions. This court therefore finds that respondents Bradlau and Tone are neither necessary nor proper parties to the cause of action for judicial dissolution and the imposition of a surcharge pursuant to Business Corporation Law 1104-a (a) (1)(2) and (d).

With respect to the accounting claim, the court held that the petition “fails to allege an attorney-client relationship or a fiduciary relationship between the petitioners who are individual shareholders of Eagle, and Bradlau and Tone,” only “the existence of a fiduciary relationship between the corporation and its counsel,” and that in the “absence of a fiduciary relationship between petitioners and Bradlau and Tone, the petition fails to state a cause of action for an accounting.”

Observations

Why did the petitioners choose the errant path of suing their outside law firm for a surcharge under BCL 1104-a(d) rather than simply bring a hybrid petition/complaint alleging one or more substantive causes of action? The likely answer is the statute of limitations, which is three years for attorney malpractice, and three or six years depending on the relief sought for breach of fiduciary duty. Under a three-year statute, their putative claims were clearly time barred, so perhaps rather than risk it, they sued for a surcharge under BCL 1104-a, which as we noted recently is subject to a six-year statute of limitations.

Did the Telano court adopt a clear standard to help future courts determine whether one is “in control” of a business for purposes of imposing a surcharge? Unfortunately not. The closest was the court’s remark that Bradlau and Tone were not “shareholders, officers, directors or employees” of Eagle. On the right set of facts, perhaps any one of those four classes of persons could be deemed to “control” the entity.

Could a “silent investor” qualify as a “control” person under section 1104-a? One could imagine a sufficiently well-crafted, factually detailed petition one day getting past a dismissal motion by alleging a silent investor controlled a corporation to such an extent that it should be surcharged for misconduct. Given the rarity of surcharge cases, whether we will ever see such a petition is another question.