Application of a Company’s By-Laws to Director Deadlock

• Posted on: Jun 20 2023

A couple of months ago, we examined NW Media Holdings Corp. v. IBT Media Inc., 2023 N.Y. Slip Op. 30875(U) (Sup. Ct., N.Y. County Mar. 22, 2023) (here), a case in which a lower court addressed the question whether the destruction of millions of pages of data on a Google Workspace states a claim for trespass to chattels or conversion (here). As discussed in that article, the court concluded that the allegations concerning the destruction of such data sufficed to state a claim for conversion.

NW Media is once again the subject of an article, this time in the context of board deadlock – that is, when the members of a company’s board of directors are deadlocked regarding the vote on a matter of corporate concern. NW Media Holdings Corp. v. IBT Media Inc., 2023 N.Y. Slip Op. 03288 (1st Dept. June 15, 2023) (here).

NW Media was one of four interrelated cases in which former friends and business associates, Johnathan Davis and Dev Pragad, vied for control over Newsweek. Pragad, as president of NW Media Holdings Corp. (“NW Media”), which owned Newsweek LLC and related entities, had caused NW Media to sue IBT Media Inc., an entity that Davis controlled. NW Media sought indemnification for alleged losses under the Membership Interest Purchase Agreement dated December 13, 2018 (“Purchase Agreement”). IBT moved to dismiss, arguing, among other things, that the lawsuit should have been brought derivatively, not as a direct action in the name of the corporation.

As noted by the motion court, the outcome of the action was dependent upon the application of one of two distinct lines of cases – lines of cases that lead to opposite results.

The Seeming Split in Authority

Under the first line cases, decided by the Court of Appeals in 1949, Sterling Industries Inc. v. Ball Bearing Pen Corp., the president was held to be without authority to initiate litigation due to board deadlock. In Sterling, two groups controlled the plaintiff corporation on a 50/50 basis.¹ A pen company, whose representatives comprised one of the groups, had agreed to make the plaintiff the exclusive sales agent for the pen company’s fountain pens for one year. The president of the plaintiff called a special meeting of the board of directors to consider whether or not to sue the pen company for breach of contract. The two directors representing the plaintiff said yes, while the two directors representing the pen company voted no. Thus, the board was deadlocked.

The Court of Appeals held that, where the by-laws of the corporation did not allow the president to commence litigation, but instead provided that the act of a majority of the board should constitute the act of the board, the authority of the president to commence litigation terminated “when a majority of the board of directors at the special meeting refused to sanction it.”² In so holding, the Court reasoned that the intention of the parties controls as reflected in the governing corporate documents:

The circumstances of the organization of plaintiff corporation indicate that the parties intended that the corporation should be managed by its board of directors and that the board should take no affirmative action if not sanctioned by a majority. That is the arrangement the parties intended and there is no basis on which to hold such an arrangement illegal. Had the Legislature intended to eliminate the problem of a deadlock it could have done so by the simple expedient of requiring an odd number of directors. Instead, apparently realizing the desire for equal control in some closely held corporations, it has continued to permit the election of a board of directors with an even number of directors. The fact that a deadlock may result does not necessarily mean that the present law is inadequate and that it should be remedied by the approval of presidential power where none in fact exists thus disregarding fundamental rules of agency law.”³ 

Although the Court of Appeals did not leave the plaintiff a direct remedy, it, nevertheless, noted the availability of a derivative action.⁴

Subsequent to Sterling, the courts in New York held that where a company’s bylaws do not expressly give the president the right to commence litigation, and there is board or shareholder deadlock about the propriety of doing so, the president lacks the authority to bring an action directly in the name of the corporation. For example, Crane, A.G., v. 206 West 41st Street Hotel Assoc LP, involved a fight among shareholders about whether or not to defend a foreclosure action.⁵ The stockholder’s agreement specified that any action of the board required unanimous approval of the directors and that any action of the stockholders themselves required unanimous approval.⁶ The defendant company was owned 50/50 between two additional LLCs. Separate individuals owned these additional LLCs. The individual who owned one of the 50/50 owners of the defendant also owned the plaintiff/lender. When the lender sought to foreclose on property, the 50/50 board deadlocked on whether or not to defend the action.

Relying on Sterling, the Appellate Division, First Department held that the general partner of the other LLC/president, who had wanted to defend against the foreclosure, had no authority to do so. In reaching this conclusion, the Court noted that the president could not act against the wishes of his co-owner when the agreement between the two required unanimous approval and that the president’s “actual authority to defend the foreclosure action was terminated when the stockholders refused unanimously to sanction it.”⁷ As in Sterling, the First Department noted the availability of a derivative lawsuit for breach of fiduciary duty in the event the failure to defend the foreclosure was improper.⁸

In Stone v. Frederick, the plaintiff, the 50% owner of the company sued the defendant, the other 50% owner, in an attempt to take over the company. In dismissing the case, the court held “where there are only two stockholders each with a 50% share, an action cannot be maintained in the name of the corporation by one stockholder against the other with an equal interest and degree of control over corporate affairs; the proper remedy is a stockholder’s derivative action.”⁹ 

The second line of cases started with Paloma Frocks, Inc. v. Shamokin Sportswear Corp.,¹⁰ a case in which the New York Court Appeals appeared to walk back the holding in Sterling.

In Paloma, the issue on appeal was for a stay of arbitration. The Court held that, because the corporate president of the defendant had authority to execute the underlying contract containing an arbitration clause, the president also could initiate arbitration under that contract.¹¹ Years earlier, Paloma had entered a contract with Shamokin whereby Shamokin was to help Paloma manufacture dresses. Shamokin contended that Paloma owed it for services under the contract. The contract contained an arbitration clause.

Paloma’s president, Harry Toffel, also owned 50% of Shamokin. Paloma, through Toffel, countered with a proceeding to stay arbitration. Bernstein, Shamokin’s president, admitted that the Shamokin directors had not acted in the matter and that a meeting of Shamokin’s board would have been an “idle gesture” because the Toffel side, which controlled 50% of Shamokin, as well as owning Paloma, would never have voted in favor of Shamokin suing Paloma.

The Court of Appeals held that Bernstein, as president of Shamokin, had the presumptive authority to commence arbitration. The Court reasoned that there had been no direct prohibition from the board of directors. Moreover, the Court reasoned that, because all the directors had previously agreed to the contract containing the arbitration clause, they had already agreed in advance that “Paloma-Shamokin controversies would go to arbitrators.”¹² Bernstein was simply carrying out a previously agreed upon arrangement.¹³ The Court did not address whether the arbitration should have been brought as a derivative action or whether the arbitrators could have dealt with the derivative/direct issue.

One year later, the Court of Appeals decided West View Hills Inc. v. Lizau Realty Corp.¹⁴ In West View Hills, the plaintiff sued the defendant, along with its officers and stockholders, for saddling it with certain construction costs. The officers of the parties were identical. The president, who held a minority interest, had caused the plaintiff to bring the suit.

In allowing the suit to proceed, the Court of Appeals distinguished West View Hills from “the classic case requiring resort to a stockholder’s derivative action to protect minority interests.”¹⁵ The Court distinguished Sterling, noting that the West Hills board had taken no action, while the Sterling board refused to sanction the president’s authority to bring the suit.¹⁶ 

Following Sterling and Paloma, courts have tried to balance the two lines of authority by drawing a distinction between the presumptive authority of the president and a negative board vote.¹⁷ 

The Motion Court’s Decision and Order

Prior to bringing the lawsuit, Pragad showed Davis a draft complaint, to which Davis strenuously objected in writing. Although there was no formal vote because Pragad ignored Davis’ request for a board meeting, Davis’ objection created a deadlock as Davis and Pragad each owned 50% of the company.

The motion court held that “[t]his case fits squarely into Sterling.” The motion court noted that the bylaws of NW Media did not confer a right on the president to commence litigation. Instead, said the motion court, the bylaws specifically stated that “the business of the corporation shall be managed by its board of directors,” and, pursuant to section 8(a) therein, required a vote of the majority of the board to act. The motion court further noted that the by-laws contained a tie-breaking mechanism for director deadlock in section 8(d): “If the Board of Directors is unable to act because they are deadlocked (an equal number of Directors have voted for and against a matter duly presented to the Board for vote), the matter shall be referred to the Shareholders of the Corporation for a vote pursuant to Article II of these By-Laws.”

Thus, the motion court found that NW Media’s corporate by-laws required a vote of the majority of the board of directors or, in the event of deadlock, the shareholders. 

Looking at the conduct of the parties, the motion court found that, although there was no formal vote of the board, Davis did not consent. To the contrary, as noted, he opposed the filing of the lawsuit. Thus, according to the motion court, the board was deadlocked, there being only two

members. Accordingly, under Sterling and its progeny, concluded the motion court, as the president of a closely held corporation, Pragad lacked the authority to act unilaterally against Davis’ interest.

The motion court rejected plaintiffs’ claim that because there was no vote, Sterling was inapplicable. The motion court explained that plaintiffs ignored section 8(a) of the by-laws, which unambiguously required a vote for the board to act. Without one, said the motion court, no lawsuit could be commenced. Additionally, the motion court observed that Davis asked for a board vote, but the request was ignored, a fact that was undisputed.

The motion court also rejected plaintiffs’ attempt to “fit this case into the Paloma line of cases,” by arguing that because Davis and Pragad executed a “Unanimous Written Consent”, whereby they both as directors of NW Media authorized the other to “execute the [Purchase Agreement], and any and all instruments, writings and other documents necessary to carry out the transaction contemplated under the [Purchase] Agreement”: 

All the “Unanimous Written Consent” entailed was authorization to enter into and carry out the purchase of Newsweek. That “Unanimous Consent” cannot override contemporaneously executed by-laws that require a majority of the board of directors to act and provide for resolution of deadlock, at least in theory.

The motion court noted that the transaction referred to in the consent was the purchase of Newsweek. Regardless, the motion court held that the consent could not “help NW Media escape the plain text of the corporate bylaws, that require a vote of the majority of the board of directors to act.” “To suggest otherwise elevates form over substance,” said the motion court.

The motion court also noted that even with the tie-breaking provision of the bylaws, there was still deadlock as Davis and Pragad were the only shareholders of the company: 

Because the by-laws in section 8(d) refer a matter to a shareholder vote in the event of deadlock, the by-laws specifically contemplated deadlock. The problem is NW Media has only two shareholders: none other than Pragad and Davis. Thus, there is no way, as a practical matter, to break the tie. What is apparent from the by-laws, though, is that Pragad and Davis bargained for equal control of NW Media and contemplated the possibility of board deadlock if they did not agree. 

The motion further held that the case before it also “differ[ed] from Paloma because, in Paloma, there was no board objection prior to the president bringing suit.” “Here,” by contrast noted the motion court, “Davis vociferously objected.”

Finally, the motion court noted that neither Paloma nor West Hills involved a dispute between two 50/50 shareholders.

In conclusion, the motion court held that “the situation at hand fits precisely into the Sterling line of cases. Although IBT may have a separate duty to NW Media, the fact remains Davis controls IBT and Davis has objected to the institution of the suit. This leaves plaintiff, who is essentially Dev Pragad, recourse through a derivative suit only.”

Accordingly, the motion court granted IBT’s motion to dismiss without prejudice to plaintiffs commencing a derivative action.

The First Department’s Decision

On appeal, the Appellate Division, First Department unanimously affirmed. 

The Court held that the “motion court correctly granted IBT’s motion to dismiss the complaint,” pursuant to the authority set forth in Sterling.¹⁸ The Court held that “Pragad lost his presumptive authority to initiate this action in the corporation’s name because NW Media’s board was deadlocked.”¹⁹ “As in Sterling,” said the Court, “NW Media’s by-laws provide[d] that ‘the business of the Corporation shall be managed by its Board of Directors,’ and that ‘the vote of a majority of the Directors present at the time of the vote … shall be the act of the Board of Directors.’”²⁰ Noting that plaintiffs did not dispute the fact that Davis “expressly objected to the filing of the complaint, which left the board deadlocked,”²¹ the Court concluded that “any actual or implied authority Pragad may have had to commence this action was ‘terminated when a majority of the board … refused to sanction it.”²² “Even without a formal board meeting,” explained the Court, “which Davis requested, to no avail, his affirmative written objection constituted a ‘direct prohibition by the board’ sufficient to constitute a deadlock.”²³ 

The Court also rejected plaintiffs’ reliance on Paloma, noting that, in Paloma, “Paloma was objecting to something to which it had already consented in the parties’ contract: resolving disputes through arbitration”²⁴: 

Here, IBT’s agreement to the purchase agreement, through Davis, may have included an agreement to indemnify NW Media under certain conditions, but it did not constitute a broad agreement to Pragad’s initiation of litigation against IBT on behalf of NW Media absent board approval. By taking that action, Pragad was not “merely carrying out an existing agreement” constituting “a routine step in the performance” of the contract, as was the case in Paloma.²⁵

Takeaway

As noted, since Sterling and Paloma were decided, New Yorks courts have tried to balance the two lines of authority by drawing a distinction between the presumptive authority of the president and a negative vote of the board of directors. NW Media illustrates this balancing act. As both the motion court and the First Department noted, “Pragad lost his presumptive authority to initiate [a direct] action in the corporation’s name because NW Media’s board was deadlocked.”²⁶ As in Sterling, “NW Media’s by-laws provide[d] that ‘the business of the Corporation shall be managed by its Board of Directors,’ and that ‘the vote of a majority of the Directors present at the time of the vote … shall be the act of the Board of Directors.’”²⁷ In NW Media, there was no dispute that Davis vehemently opposed the filing of the lawsuit, thereby leaving the board deadlocked.²⁸ Thus, as in Sterling, “any actual or implied authority Pragad may have had to commence this action was ‘terminated when a majority of the board … refused to sanction it.”²⁹

Given the importance New York courts give to an entity’s governing corporate documents, such as bylaws and operating agreements, Sterling and its progeny, of which NW Media is a part, makes sense. This is not to say that facts and circumstances may counsel in favor of a different result, as in Paloma and its progeny. But when the board of directors has resolved (whether affirmatively or through deadlock) to prohibit the president from initiating a lawsuit, the president is without authority to institute such action.

Footnotes

1. 298 N.Y. 483 (1949).
2. 298 N.Y. at 490.
3. Id. at 491–92; see also COR Mktg. & Sales, Inc. v. Greyhawk Corp., 994 F. Supp. 437, 441 (W.D.N.Y. 1998). As noted by the motion court, other jurisdictions, such as Delaware (8 Del. C. 1953, § 353) and Maine (13-C M.R.S.A. § 1434), provide tie breakers by statute. New York does not.
4. Id. at 493.
5. 87 A.D.3d 174 (1st Dept. 2011).
6. Crane, 87 A.D.3d at 176.
7. Id.
8. Id. at 179.
9. 245 A.D.2d 742, 745 (3d Dept. 1997); see also Giaimo v. EGA Assocs., 68 A.D.3d 523, 524 (1st Dept. 2009).
10. 3 N.Y.2d 572 (1958).
11. Id. at 575.
12. Id.
13. Id.
14. 6 N.Y.2d 344 (1959).
15. Id. at 347.
16. Id. at 348.
17. See328 56th Rest., Inc v. Polldon Rest. Inc., 39 A.D.2d 689, 690 (1st Dept. 1972) [“‘[w]hile the president of a corporation has presumptive authority to prosecute suits in the name of a Corporation …, such presumption would not obtain where the Board of Directors has resolved to the contrary or failed to authorize the President to institute such action [in the by-laws”]; Fernandez v. Hencke, 93 A.D.3d 440, 441 (1st Dept. 2012) (“[w]here there is no direct prohibition by the board, the president of a corporation has presumptive authority, in the discharge of his duties, to defend and prosecute suits in the name of the corporation”); Family M. Foundation v. Manus, 71 A.D.3d 598, 599 (1st Dept. 2010) (“This is not a case where one 50% shareholder seeks to assert a claim on behalf of the corporation against another 50% shareholder who possesses an equal degree of control.”).
18. Slip Op. at *1.
19. Id.
20. Id.
21. Id.
22. Id. (quoting, Sterling, 298 N.Y. at 489, and citing, Crane, 87 A.D.3d at 176)).
23. Id. (quoting, Rothman & Schneider v. Beckerman, 2 N.Y.2d 493, 497 (1957)).
24. Id. at *2.
25. Id.
26. Id.
27. Id.
28. Id.
29. Id. (quoting, Sterling, 298 N.Y. at 489, and citing, Crane, 87 A.D.3d at 176)).

Jeffrey M. Haber is a partner and co-founder of Freiberger Haber LLP.

This article is for informational purposes and is not intended to be and should not be taken as legal advice.