When bankruptcy interrupts corporate dissolution proceedings, it usually means bad news for the petitioner.  For instance, last year I wrote about a petition for corporate dissolution doomed by the petitioner’s failure to disclose his stock interest in prior bankruptcy proceedings.  A recent decision presents an interesting departure from the norm, involving a dissolution case commenced in 1990 that took a 10-year detour through bankruptcy court before returning to state court to resume a buyout proceeding.  The case, Smith v. Russo, 2009 NY Slip Op 32785(U) (Sup Ct Queens County Nov. 13, 2009), raised the question whether the bankruptcy court’s basis for rejecting as inadequate a buyout settlement proposed by the bankruptcy trustee should be given collateral estoppel effect — for the benefit of the former bankrupt — in the subsequent state court valuation proceeding.

Husband and wife Richard and Nelsi Smith were 27.5% shareholders of Meadow Mechanical Corporation formed in 1980.  In 1990, the other shareholders removed Richard as president and barred both Smiths from the business premises, prompting the Smiths to sue for dissolution under Section 1104-a of the Business Corporation Law.  The other shareholders then elected to purchase the Smiths’ shares for fair value under BCL Section 1118.

The case fell into a six-year quagmire featuring an initially successful, contested revocation of the buyout election due to the bankruptcy of one of the purchasing shareholders, followed by a reversal on appeal.  Then, in 1996, petitioner Richard Smith filed for bankruptcy.  The dissolution proceeding and a separate action against Meadow on a $275,000 promissory note were the only assets of the debtor’s estate.  The trustee in bankruptcy asked the bankruptcy court to approve a $350,000 settlement for both matters, which Smith and the creditors opposed.

The bankruptcy court held an evidentiary hearing including testimony by accountants for the trustee and Smith, and by the accountant who prepared Meadow’s financial statements.  In its decision, the court approximated Smith’s share of the company earnings to be $300,000 and, after applying an earnings multiplier and discount for lack of marketability, concluded that “the value of the Debtor’s interest in Meadow would most likely increase to no less than $600,000.”  On that ground the court in 2003 entered an order denying the trustee’s motion to approve the settlement, stating that the proposed settlement “does not adequately reflect the value of the Dissolution Action and the note owed to the Debtor’s estate.”

The trustee appealed to the federal district court which affirmed the bankruptcy court’s ruling in 2005, following which the bankruptcy court authorized the trustee to abandon to the debtor the claims of the debtor against any party.  In 2006 — 16 years after the action started — the state court restored the valuation proceeding to active status.

The Smiths then sought to leverage the bankruptcy court’s order by moving for partial summary judgment in the valuation proceeding.  Their motion asked the state court to rule on the basis of collateral estoppel that the minimum value of their Meadow shares was $600,000 for Richard’s shares and a proportionate amount of $133,333 for Nelsi’s shares.  In other words, they wanted the court to set a $733,333 floor for the combined value of their shares, subject to their offering evidence at a later hearing of an even higher value.

For the uninitiated, collateral estoppel, also referred to as issue preclusion, is based upon the general notion that a party, or one in privity with a party, should not be permitted to relitigate an issue decided against it.  The party seeking the benefit of collateral estoppel must prove (1) that the identical issue was necessarily decided in the prior action and is decisive in the present action, and (2) that the party to be precluded from relitigating an issue had a full and fair opportunity to contest the prior determination.

The decision by Queens County Supreme Court Justice Peter J. Kelly found that the Smiths satisfied neither of the two required elements.  With respect to identity of issues, Justice Kelly stated that the issue before the bankruptcy court under federal bankruptcy law was whether the trustee’s proposed settlement “fell below the lowest point in the range of reasonableness,” whereas the issue in the state court valuation is “what is actually the proper full value of the plaintiff’s shares in Meadow.”  Justice Kelly elaborated:

At most, as part of its inquiry into the reasonableness of the proposed settlement, the bankruptcy court resolved the issue of what was the minimum reasonable value of the plaintiff’s shares in Meadow.  This court need not resolve that issue in a dissolution proceeding, but rather must determine the actual, full value of the plaintiff’s shares. . . . The figure arrived at by the bankruptcy judge as the minimum reasonable value of the plaintiff’s shares was just an estimate.  The bankruptcy judge expressly noted that her function was merely to “canvass” the issues in the underlying litigation, “not to decide the issues of fact and law ” raised therein.  The bankruptcy judge speculated about the weight this court would give to certain financial documents, and stated in a tentative manner: “For the sake of argument, this court would reduce the Debtor’s interest in Meadow to $300,000.”  (Italics added.). The bankruptcy judge did not take evidence on the crucial matter of the “multiplier” to be applied to the $300,000 in estimated earnings, but merely picked a conservative number suggested by other cases.

On the second element, Justice Kelly found that the other Meadow shareholders did not have a full and fair opportunity to litigate the issue pertaining to the minimum value of Smith’s interest in Meadow.  “They were not parties to the bankruptcy proceeding,” wrote Justice Kelly, “and the only parties to the motion for an order approving the proposed settlement were the trustee in bankruptcy, Smith, and creditors who opposed the proposed settlement.”  Nor were the other shareholders in privity with the trustee.

Justice Kelly’s discomfort with the Smiths’ application went further.  The Smiths were trying to set a valuation floor from which the ultimate determination of value could only go higher.  This approach, however, left open the possibility of a state court determination “inconsistent” with that of the bankruptcy court.  As Justice Kelly further explained:

[Smith’s] procedural maneuver does not advance the policies underlying the doctrine of collateral estoppel, one of which is the prevention of inconsistent decisions by different courts.  This court may, for example, find a different multiplier, if any, to be appropriate, thereby drastically altering the value up or down to be placed on Smith’s shares.  Moreover, conservation of resources, the other policy consideration underlying the doctrine of collateral estoppel, will not be promoted in this case where the issue of valuation will have to be tried de novo. [Citations omitted.]

The decision mentions Smith’s allegation that, in connection with his bankruptcy, the other shareholders initially offered $400,000 to the trustee and subsequently $350,000 for Smith’s interest in Meadow.  One can speculate that the other shareholders might have been able to conclude the case then and there had they formally intervened in support of the trustee’s motion to approve the settlement, and had they offered a full-fledged, expert appraisal bolstering the fairness of the amount.  At least from a collateral estoppel standpoint they would have been no worse off for trying based on Justice Kelly’s analysis of the differing, substantive standards in the bankruptcy and state court valuation proceedings.