Inadequate and erroneous documentation of ownership is an all too common feature of closely held businesses and, after disputes arise, a wellspring for litigation over an aggrieved business partner's standing to assert financial claims or to seek judicial dissolution.

The reasons for this state of affairs are many and diverse, e.g.:  The owners lack a sophisticated understanding of the legal formalities attendant to ownership of the chosen form of business entity.  The owners are unable or unwilling to spend the money for proper legal and accounting services.  The owners are family members or long-time friends who trust one another and believe they don't need any written agreement or certification of ownership interests.

When litigation erupts and the complaining party's ownership interest is challenged, in the usual case the issue is whether the complaining party ever became a shareholder or, if the case involves a limited liability company, ever held a membership interest.  This type of dispute has been the subject of more posts on this blog than almost any other single subject.  (Click on the topic "Standing" on the right sidebar and you'll see what I mean.)

A decision last month by Nassau County Commercial Division Justice Stephen A. Bucaria in Gitlin v. Chirinkin, Short Form Order, Index No. 012131/07 (Sup Ct Nassau County June 29, 2011), presents a twist on the usual fact pattern.  In Gitlin, no one contested that the plaintiff became a 50% member of the subject LLC at its inception.  Rather, the issue was whether the plaintiff's membership interest subsequently terminated, as the other 50% member contended, such that the plaintiff had no entitlement to share in the profits of transactions that took place after his alleged termination.

Background

Plaintiff Eduard Gitlin and defendant Alex Chirinkin were close friends and business associates in March 1997 when they formed Kew Apartment Holdings, LLC ("Kew") to buy and sell New York City co-op apartments.  Gitlin, a licensed real estate broker, oversaw the investments, the last of which was sold in 2001.  Gitlin's lawsuit did not make any claims regarding those investments.

Rather, the claims involve two Nevada real properties acquired in 1998 known as the Pahrump and Lucky Bucks properties.  The Pahrump property was purchased for about $1.14 million, owned 20% by Kew and 80% by another LLC wholly owned by Chirinkin.  Neither Gitlin nor Kew contributed any cash toward the purchase price, although Gitlin did co-sign with Chirinkin on Kew's behalf an installment note and escrow agreement.  In 2003, Chirinkin, acting alone and without Gitlin's knowledge, conveyed title for no consideration to another LLC wholly owned by Chirinkin (75%) and to an individual named Arkady Pavlov (25%) who paid Chirinkin (or one of his companies) $230,000.  In 2005, following an interim conveyance to yet another Chirinkin-controlled company, the Pahrump property was sold to a third-party buyer for $15.8 million.

The Lucky Bucks property was purchased for about $530,000 with title held jointly by Kew (50%) and two outside investors, one of whom was later replaced by Pavlov.  In 2002, the Lucky Bucks property was sold to the U.S. government for about $1.63 million.  At the time Gitlin had no knowledge of the Lucky Bucks acquisition or its subsequent sale.

None of the sale proceeds from the Pahrump or Lucky Bucks transactions was paid to Kew.

A Lengthy Litigation

In 2007, after learning about the Pahrump deal, Gitlin sued Chirinkin, Chirinkin's wife, Pavlov and two of Chirinkin's other companies for various claims brought individually and derivatively on Kew's behalf, including conversion, fraud, unjust enrichment, fiduciary breach and fraudulent conveyance.  In a decision dated November 21, 2007 (read here), Justice Bucaria dismissed all the derivative claims -- this was before the Court of Appeals in the Tzoliz case recognized common law derivative claims by LLC members -- and several other claims either as time barred or insufficiently pleaded.

In an October 2008 decision (read here), Justice Bucaria reinstated Gitlin's derivative claims (this followed the February 2008 Tzoliz decision) and granted leave to add claims relating to the Lucky Bucks transaction which Gitlin apparently first learned about in discovery.  In March 2009, the Appellate Division, Second Department, denied Chirinkin's appeal from this decision (read here).

In a July 2009 decision (read here), which also was affirmed on appeal in March 2010 (read here), Justice Bucaria denied a defense motion to compel Gitlin to produce his personal tax returns and bank statements which, Chirinkin argued, he needed to prove that Gitlin no longer had a membership interest in Kew when the Pahrump and Lucky Bucks properties were sold.  Justice Bucaria's decision notes that Section 9.1 of Kew's operating agreement dated March 1997, which lists Gitlin as a 50% member, "requires some affirmative action to accomplish the withdrawal of a member and that must be accomplished 'either in writing or at a meeting called for such purpose.'"  According to Justice Bucaria, defendants' failure to produce evidence of such an event creates "a clear presumption that such membership continues" thus rendering immaterial "defendants' demand for documentation to prove the negative."

The Summary Judgment Arguments

In March 2011, Gitlin moved for summary judgment seeking recovery of all of the sale proceeds from the Pahrump and Lucky Bucks transactions.  Gitlin's memorandum of law (read here) argued that Chirinkin's sale of the properties violated Section 402(d)(2) of the LLC Law and Section 5.5 of Kew's Operating Agreement requiring the consent of two-thirds in interest of the members; that Chirinkin's transfers of title out of Kew for no consideration breached his fiduciary duty as manager under Section 409 of the LLC Law; and that the transfers also constituted unjust enrichment and fraud under common law and the provisions of the Debtor and Creditor Law.

Chirinkin's opposition brief (read here) argued against summary judgment based on questions of fact surrounding the status of Gitlin's membership in Kew when the properties were sold.  Chirinkin contended that Gitlin contributed no funds to acquire or maintain the properties; that Gitlin spent no time managing the properties; that Chirinkin acquired the two properties by partially placing them in the name of Kew solely "for accounting purposes"; that Kew's tax returns for the years 1998 through 2001 did not show Gitlin as a member of Kew; that Kew's former accountant swore that Gitlin was not a member of Kew; and that the Operating Agreement produced by Gitlin during the litigation, which Gitlin originally denied existed, was bogus.  Chirinkin also argued that because Kew initially held only a 20% interest in the Pahrump property, the 80% member (Chirinkin's other company) had an unrestricted right to transfer it to a third party.  Chirinkin also argued that Gitlin commenced the lawsuit in an attempt to avoid repaying a $430,000 loan made by Chirinkin to Gitlin in 2006.

In his reply (read here), Gitlin argued that the 1998-2001 tax returns omitting Gitlin's membership should not be considered based on Chirinkin's deposition testimony in which he "would not confirm that they were true and accurate copies of the tax returns."  Gitlin also cited Chirinkin's testimony that he alone provided the company's accountant with the information contained in its tax returns.  Gitlin further argued that the Court's July 2009 discovery ruling, in which it denied production of Gitlin's tax returns based on the absence of evidence that he withdrew from the LLC, constituted the law of the case and was dispositive of Gitlin's member status. 

The Court's Ruling

Justice Bucaria's legal analysis of Gitlin's member status initially quotes from the court's July 2009 decision but neither accepts nor rejects Gitlin's argument based on the law of the case.  Rather, Justice Bucaria finds that, "even without that prior decision, the submitted evidence on this motion clearly establishes that Gitlin was a member of Kew with a 50 percent interest."  Such evidence includes:

  • Kew's Articles of Organization
  • Kew's Operating Agreement
  • the $696,050 Installment Note for the Pahrump acquisition co-signed by Gitlin
  • the Escrow Agreement for the Pahrump down payment co-signed by Gitlin

As in his prior discovery ruling, Justice Bucaria finds, in what appears to be the most critical aspect of his ruling on this point, that Chirinkin

has failed to come forth with any evidence that an event of withdrawal occurred as required pursuant to Article IX, section 9.1 [of Kew's Operating Agreement].

Based on these findings Justice Bucaria grants summary judgment of liability against Chirinkin for breach of Section 5.5 of the Operating Agreement, breach of fiduciary duty under LLC Law Section 409, common law fraud for misrepresentations and omissions concerning the two properties, unjust enrichment, and fraudulent conveyance for transferring the properties for no consideration with actual intent to defraud Gitlin under Sections 273 and 276 of the Debtor and Creditor Law.

Justice Bucaria stops short of awarding damages and instead orders a trial, finding that

Chirinkin has raised an issue of fact as to the profit which Kew made upon the sale of the Nevada properties . . . [and] as to the damages which Gitlin suffered based upon the loss of his 50 percent share of the net profits realized by Kew upon the sale of the properties. . . . Accordingly a trial is necessary to determine the issue of damages.

I end as I began, with the observation that, for any number of reasons, a significant portion of the population of business owners always will conduct their affairs, record their business transactions, and report those transactions to tax authorities in ways that ignore or contradict the  formalities and obligations imposed by the statutes that govern the chosen entity form and by the parties' shareholders agreement, by-laws or operating agreement.  Sometimes the motives are innocent, sometimes not, but either way, the risks are very real and, as in Gitlin, can turn out to be very costly.