Stavroulakis v. Pelakanos, 58 Misc. 3d 1221(A) (N.Y. Sup. Ct. 2018), begins with a scenario familiar to anyone who frequently deals with business divorces. As an entity matures and succeeds, active investors in the business devote more and more time to it, while passive investors, whose capital may have been critical in the early going, continue to be passive but reap the rewards of the now-successful business to the dismay of the active investors.

The case concerned the Bareburger burger restaurants, which are primarily located in the United States, but also abroad. In all, there were six Bareburger founders, including plaintiff John Stavroulakis. Over time, they founded corporations, including one to franchise Bareburger restaurants (the “Corporation”). They developed a logo and received a trademark.

Within a year of opening the first Bareburger in June 2009, the other founders (the “Founder Defendants”) had become frustrated by the relatively small amount of money they all had invested, including Stavroulakis, versus the significant amount of labor and time involved for everyone except Stavroulakis.

This frustration apparently led the Founder Defendants to take actions in violation of their duties to Stavroulakis and the Corporation. On April 1, 2011, they transferred all of the assets of the Corporation to Bareburger Group, LLC (the “LLC”) for no consideration. The Founder Defendants were equal 20% members in the LLC, but Stavroulakis was given no interest, nor was he told of its formation. The Founder Defendants continued to transfer assets from the Corporation to the LLC for no consideration even after Stavroulakis eventually got wind of the LLC and asserted his rights.

Stavroulakis filed a host of derivative actions on behalf of the Corporation against the Founder Defendants as well as a host of direct actions against them. After discovery, Stavroulakis moved for summary judgment on liability on his direct and derivative breach of fiduciary duty claims, among others. The court granted summary judgment.

All shareholders and officers of closely held corporations, like the Founder Defendants, owe fiduciary duties of care and loyalty to the corporation. These duties are breached where officers and directors engage in transactions that hurt the corporation in favor of their own or another entity’s interests.

Generally, officers and shareholders in closely held corporations are protected by the business judgment rule, which provides the presumption that their actions were faithful to the corporation. When the business judgment rule does not apply, officer and shareholder actions are subject to the entire fairness standard. The Stavroulakis court held that entire fairness applied to the transfer of assets from the Corporation to the LLC for three reasons.

First, entire fairness applies to transactions in which the corporate officers have a personal interest, such as the transfer of assets from the Corporation to the LLC, in which the Defendant Founders had an interest. Second, entire fairness applies where there is a waste of corporate assets. “The transfer of assets without consideration and permitting corporate property to be given to a foreign corporation without consideration are classic examples of waste.” Id. at *11 (alterations and internal quotation marks omitted). Third, entire fairness applies where directors divert corporate opportunities from the corporation “to other companies in which neither the corporation nor its minority shareholder has an interest.” Id. at *11. This includes where “a director secretly forms a new entity and transfers the corporation’s entire business to that entity.” Id. at *12.

Where entire fairness applies, corporate officers and directors have the burden of proving that the transactions in question were fair to the minority and the company. If they were not, the subject transactions will be deemed breaches of fiduciary duty. Apparently, the Founder Defendants made no attempt to meet their burden. In fact, the Founder Defendants did not even use the phrase “entire fairness” in their brief, abdicating their burden of showing that the consideration paid for the assets was fair.

Instead, the Founder Defendants apparently invoked “the concept of ‘fairness’ by contending that it was fair to cut plaintiff out of [the Corporation] because he was not working for it.” Id. at *12. The court held that there was no legal basis for this because the Corporation’s documents did not require Stavroulakis or anyone else to work for the business. “Rather, [the Founder Defendants] relied on a subjective belief that plaintiff’s lack of contributions warranted taking plaintiff’s interest in the company.” Id. at *13. According to the court, such a “belief is misguided at best and disingenuous at worst.” Id.

This illustrates the lesson in the case. In a business divorce, it is critical for principals to get good legal advice early in the process. That could mean drafting a shareholder agreement that conditions equity retention on further contributions of labor or capital up front, or advising the proper way to remove a minority shareholders, such as a buyout or freeze-out merger — both possibilities the court noted were available.

The Founder Defendants got neither. The court noted its “dismay” that a lawyer was involved in the “illegal transaction” delivering the Corporation’s assets to the LLC for no consideration. Id. at *13 n.26. This had disastrous consequences for the Founder Defendants. While damages were not at issue, the court indicated its inclination to award Stavroulakis a monetary recovery against the Founder Defendants jointly and severally. In other words, there was a “guaranteed possibility” of personal liability for the Founder Defendants upon the Court’s ruling. Id. at *13. The amount would be measured by Stavroulakis’s share of lost profits from the time the improper transactions took place, plus the present value of his share of the Corporation if the transactions had not occurred, plus attorneys’ fees under New York law. With Bareburger projected to make $90 million in sales in 2017, the number could be very high indeed, and the court commented — rightly so — that its decision “should rationally impel settlement.” Id. at *14 n.30.