Legal Blog

Case Study Of Fiduciary Abuse In A Closely-Held Corporation: How The Palm Got Out Of Hand

The Palm, a family-owned steakhouse opened in 1926, became first a New York institution, and then a powerhouse national and worldwide brand as the concept was rolled out from the original Second Avenue location by the grandchildren of the founders.

As so often happens with successful multi-generational family businesses, control, and management of The Palm, as well as equity, disproportionately settled into the hands of those family members who stayed in and actively ran the restaurant, while involvement and equity dwindled for other descendants who choose to pursue outside interests.  In the case of The Palm’s family holding corporation, after almost 90 years in business, the corporation was owned 80% by descendants who ran the operation (the “Majority Defendants”) and 20% by their cousins who did not (the “Minority Plaintiffs”).[1]  Unfortunately, as also happens in such scenarios, the insiders here took the opportunity to palm a few extra dollars for themselves — quite a few actually — at the expense of their cousins on the outside.  Therein lies the rub and the juicy facts which led the minority cousins to bring a derivative action in New York Supreme Court, New York County.  The result was a decision by Judge Masley, in GANZI v. GANZI, (Index No. 653074/2012), NYSCEF Doc. No. 253, filed November 15, 2018.

Recipe for Litigation

At the heart of the Palm case is the fact that the restaurant’s success led to the development of substantial and valuable intellectual property in the holding company: trademarks, service marks, restaurant design elements including menu, food quality choices and methods of preparation, as well as décor which included walls covered with caricatures (remember?), sketches, cartoons and other distinguishing elements.  All of this Palm IP was used, beginning in 1972, to open other Palm restaurants, first in Washington, D.C. then nationally.  The Court called these restaurants the “New Palms.”  By the time this action was brought, there were 54 New Palms, with the Majority Plaintiffs holding ownership stakes in all of them.  Each New Palm operated under a license agreement from the family holding corporation which provided for a flat fee annual royalty of $6,000 per restaurant.

Additionally, in 1975 the Majority Defendants set up a management company (wholly owned by them), which entered into a master license agreement with the family holding company, giving the management company the exclusive worldwide right to sub-license all Palm IP to third parties.  For this extremely valuable right to grant sub-licenses, the management company paid the holding company a flat annual fee of $12,000.  Under authority of the master license agreement, the management company entered into many sub-license agreements worldwide with third parties, creating “an empire of Palm-branded businesses.”  Significantly, royalties on these sub-licenses were not on a flat rate basis, but at full market rate based on a percentage of sales.

None of these arrangements wherein the Majority Defendants had substantial financial interests were submitted to the Board of the family holding corporation for approval by vote of the disinterested directors or shareholders as required under BCL §713.  In fact, shareholder and board meetings for the holding company were sporadic at best and, following a ten-year gap in meetings, such meetings were totally discontinued after 1986[1].

Out of the Kitchen and into the Courthouse

The pattern of self-dealing with the company’s valuable IP spanned forty years before the Minority Plaintiffs commenced this action.   Why they kept their claim on the back burner for so long was not addressed, but the Court had to deal with affirmative defenses of acquiescence and laches, it effectively did by finding that here the defendants were not prejudiced by the delay and that corporate waste, as established in this case, cannot be ratified.

While the Court reviewed several patterns of conduct by the defendants alleged in the complaint to constitute minority oppression, misappropriation, breach of fiduciary duty and corporate waste, Judge Masley devoted substantial discussion in her opinion to the diversion by the defendants to themselves of the restaurant’s valuable intellectual property, through their direct ownership interest in the New Palms and through the use of the master license agreement they unilaterally gave their own management company.  The Court held that, as interested parties to these flat-rate royalty agreements, the defendants did not satisfy their burden of proving, under BCL§ 713(b), that the agreements were fair and reasonable to the family company.  In fact, expert witnesses for both sides testified that “similar licensing fees in the restaurant industry are calculated as a percentage of sales.”   Although the experts differed on what the appropriate percentage should be for The Palm, the Court found that 5% of gross sales was the reasonable royalty rate that should have applied to all the license agreements.  Plaintiffs were awarded substantial money damages to the plaintiffs, thereby giving the defendants their just deserts.

The Take-Away

If Michelin gave star ratings for decisions in restaurant litigation, Judge Masley would score well.  Her opinion implicitly recognized that it is not uncommon in closely-held businesses for uninvolved family members to under-appreciate the efforts of those who devote themselves to running and growing it.  Undeniably, the defendants here had a vision for The Palm and did achieve great success.  “It is undisputed that the family was proud of [the defendants] and they had much to be proud of.”  GANZ v. GANZ, P. 16.  The defendants were entitled to be well-compensated for their efforts.  However, that success did not entitle them to enrich themselves in a way that was unfair to the corporation and the other shareholders.

It is long-established under both the Common Law and the BCL that officers and directors have an obligation to perform their duties in good faith (§§715(a) and 717(a) respectively), and that they may be held accountable for misconduct involving violation of their duties, waste of corporate assets, and unlawful transfer of corporate assets (§720).

It is also well established that transactions or agreements between a corporation and one or more officers or directors wherein such persons have a financial interest are not per se void or voidable.  But, the material facts of such transactions or contracts need to be disclosed to the Board in good faith and approved by vote of the disinterested directors, either by unanimous vote of the disinterested directors or by approval of the board without counting the vote of the interested directors (§713(a)).  If not so approved, the corporation could void them unless the interested parties carry the burden of proofing that they were fair and reasonable (§713(b)).

As noted, however, the formalities of board and shareholder meetings at The Palm went down the drain decades ago.  Although it is difficult to imagine the Majority Defendants succeeding in proving that their self-dealing license transactions were fair and reasonable, it is also difficult not to fault the Minority Plaintiffs for failing to insist on greater transparency and at least annual meetings of the Board and the shareholders.

The Palm case sends an important message to business lawyers: corporate governance is still important.  The New York Limited Liability Law, enacted twenty-five years ago, is regrettably silent on governance provisions that are explicit in the BCL.  While the current preference for LLCs over corporations as the business entity of choice is more often than not entirely justifiable, that does not excuse abandonment of basic formalities of governance that have stood the test of time.

[2] The agreement between the family holding corporation and the management company also provided for management services and compensation to the Majority Defendants.  As to this, the Court quoted from an independent report that was entered into evidence concluding that the restaurant had been grossly mismanaged, providing a “near perfect textbook example of how not to manage a restaurant.”

 


[1] Including the estate of a cousin whose surname, appropriately, was “Cook”.

[2] The agreement between the family holding corporation and the management company also provided for management services and compensation to the Majority Defendants.  As to this, the Court quoted from an independent report that was entered into evidence concluding that the restaurant had been grossly mismanaged, providing a “near perfect textbook example of how not to manage a restaurant.”


 

 

ABOUT ALLISON ROSENZWEIG

arosenzweig@offitkurman.com  |  347.589.8548

Allison W. Rosenzweig concentrates her practice in business and transactional matters for a wide range of clients, including startups, closely-held businesses, and national entities. Her experience includes mergers and acquisitions, equity financing, early-stage investing, entity formation and governance, business divorce, the drafting and review of shareholder and operating agreements, supply and distribution agreements, entertainment agreements, licensing agreements, employment and consulting agreements and a wide variety of other general corporate and commercial agreements.

 

 

 

 

 

ABOUT STUART NEWMAN

snewman@offitkurman.com  |  347.589.8546

Stuart B. Newman has been engaged in corporate and securities practice for over forty years, focusing on corporate law, private equity transactions, mergers and acquisitions, and capital formation through public offerings and private placements.

Stuart studies his clients’ businesses thoroughly and has made valuable contributions on a broad range of business topics such as joint ventures, product development, finance, investment banking, marketing, and personnel. He has served as a director on the boards of both publicly-traded and privately held companies, contributing his unique combination of business acumen and broad legal experience.

 

 

 

 

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