The so-called bad faith defense has been a staple in judicial dissolution proceedings brought by oppressed minority shareholders under § 1104-a of the Business Corporation Law (“BCL”) ever since the New York Court of Appeals articulated it in Matter of Kemp & Beatley, 64 NY2d 63 (1984):
The purpose of this involuntary dissolution statute is to provide protection to the minority shareholder whose reasonable expectations in undertaking the venture have been frustrated and who has no adequate means of recovering his or her investment. It would be contrary to this remedial purpose to permit its use by minority shareholders as merely a coercive tool. Therefore, the minority shareholder whose own acts, made in bad faith and undertaken with a view toward forcing an involuntary dissolution, give rise to the complained-of oppression should be given no quarter in the statutory protection. [Citations omitted.]
In contrast, the bad faith defense has appeared sporadically and with uncertain effect in deadlock dissolution proceedings brought under BCL § 1104, which authorizes judicial dissolution at the behest of a 50% shareholder who can demonstrate one of:
- director deadlock precluding board action;
- shareholder deadlock precluding an election of directors; or
- that “there is internal dissension and two or more factions of shareholders are so divided that dissolution would be beneficial to the shareholders.”
The great majority of deadlock cases turn on the catch-all internal dissension ground because, among other reasons, the shareholders eschew the formality of board meetings and/or the shareholders’ agreement creates permanent directorships for the two shareholders. So why has the bad faith defense fared differently in deadlock cases, and is it a viable defense at all in such cases?
Feinberg v. Silverberg
Those questions were the focus of a recent, important decision by Nassau County Commercial Division Justice Vito M. DeStefano in Feinberg v. Silverberg, Decision and Order, Index No. 3120-11 (Sup Ct Nassau County Sept. 6, 2013).
Feinberg involves a Long Island-based company called L&E International Ltd. with sales over $100 million, co-owned 50/50 by plaintiff Samuel Feinberg and defendant Errol Silverberg. According to its website, L&E is “a leading global supplier of hardline & softline print packaging and packaging related materials to the footwear, athletic and retail consumer product industries.”
In early 2011, Feinberg brought a plenary action and sought injunctive relief against Silverberg based on the latter’s alleged efforts to marginalize Feinberg’s management role, undermine his relationships with suppliers, and deprive him of compensation and distributions as part of an overall freeze-out scheme in collusion with certain other key personnel. In August 2011, the judge initially assigned to the case, who thereafter retired, granted injunctive relief based in part on statements made by Silverberg and his loyal lieutenants that were captured on an audio recording in which they explicitly discussed shutting down L&E and transferring its business to another company under their ownership sans Feinberg. (Read here my post about the decision.)
While Feinberg’s action was pending, in 2012 Silverberg filed a deadlock dissolution petition under BCL § 1104 alleging that the bitter and irreconcilable dissension between two owners, as evidenced by Feinberg’s lawsuit, made it impossible to continue L&E’s business. In May 2013, Justice DeStefano ordered the consolidation for trial of Feinberg’s plenary action and Silverberg’s dissolution proceeding (read order here).
Feinberg contended that Silverberg’s conduct in furtherance of his freeze-out scheme created the very basis for dissension, in order to obtain control over L&E’s business through dissolution, and that such bad faith conduct barred Silverberg’s dissolution petition. Silverberg contended that case precedent renders immaterial the underlying reason for the dissension, and that the petitioner’s alleged bad faith is not a cognizable defense in a proceeding under § 1104 based on internal dissension. The two sides submitted pretrial briefs supporting their opposing positions, setting the stage for Justice DeStefano’s ruling earlier this month.
Justice DeStefano’s Ruling
Justice DeStefano’s analysis initially discusses several appellate opinions that “appear, at first glance, to support Silverberg’s contention that evidence of bad faith is not relevant to the issue of dissension and deadlock amongst two 50% shareholders.” Among the cases cited are Matter of Gordon & Weiss, 32 AD2d 279 (1st Dept 1969), where the court affirmed a dissolution order holding that the good faith of the petitioner in seeking dissolution under § 1104 did not present a contested issue requiring a hearing, and Matter of Goodman, 200 AD2d 670 (2d Dept 1994), where the court also affirmed a dissolution order in a § 1104 case, stating:
[T]he underlying reason for the dissension is of no moment, nor is it relevant to ascribe fault to either party. Rather, the critical consideration is the fact that dissension exists and has resulted in a deadlock precluding the successful and profitable conduct of the corporation’s affairs.
Justice DeStefano next reviews the cases cited by Feinberg in support of his bad faith defense, including Kavanaugh v. Kavanaugh Knitting Co., 226 NY 185 (1919), where the court reinstated a complaint alleging that corporate directors sought in bad faith to dissolve the corporation for the purpose of depreciating the value of the corporate property and the plaintiff’s proportionate interest therein, and Matter of Myers, 77 AD2d 652 (2d Dept 1980), where the court vacated the lower court’s dissolution order in a § 1104 case, stating that the “[a]llegations of petitioner’s bad faith constitute a defense to a dissolution proceeding and must be heard by [the lower court] as well.”
Can the cases cited by the two sides be reconciled? Justice DeStephano concludes that they can, stating:
Upon a careful analysis of both parties’ arguments, as well as the cases which purportedly support their respective contentions, the court concludes that the cases and legal arguments, while at first blush appear to be contradictory, can, in actuality, be harmonized.
The cases cited by Silverberg, Justice DeStefano continues, have a “common thread” in that the courts ordered dissolution because there was no real dispute that “bona fide” dissension and deadlock existed between the shareholders, which made immaterial the question of fault. In the cases cited by Feinberg, however, “the dissension and deadlock was not in fact real, but, rather, feigned.” Justice DeStefano further explains:
It is this manufactured creation of the dissension which, in this court’s view, is the sine qua non of bad faith and its applicability as a defense to a judicial dissolution proceeding brought pursuant to BCL 1104(a). Simply put, in determining whether to order dissolution, while fault is of no moment when dissension and deadlock actually exist, the intent, in contrast, for creating dissension and deadlock is nevertheless relevant. Here, a manufactured dissension would belie a finding that the shareholders’ dissension poses an irreconcilable barrier to the continued functioning and prosperity of the corporation. [Citations omitted.]
Justice DeStefano, noting that the court “which sits in both law and equity, would not permit a party to avail itself of the legal system to achieve an inequitable result,” accordingly orders that the court “will permit evidence at the hearing related to Silverberg’s purported bad faith in creating dissension and deadlock . . ..”
Nine years ago I published an article in the New York State Bar Association Journal examining deadlock dissolution in which I discussed many of the same cases cited in the Feinberg decision. The article concluded that:
cases decided under the internal dissension statute exhibit something of a split personality, depending on whether the court views the corporation, successful or not, as more akin to a partnership terminable at will, or as an entity distinct from its owners, to be maintained if financially viable notwithstanding internecine warfare.
The Feinberg decision is the first, long overdue attempt by any New York court to make sense of the seemingly discordant case precedents that, on the one end of the spectrum, treat § 1104 as a no-fault statute in which the only relevant concern is whether the two owners can no longer get along and, on the other end, focus on the reasons for, and bona fides of, the alleged dissension in determining whether continuing the corporation’s existence is advantageous to the shareholders. It will be interesting to see if Feinberg has an impact in other cases, as I suspect it will.