Unclean HandsJudicial dissolution of a business entity, whether pursuant to statute or common law, is an equitable remedy subject to equitable defenses, including the doctrine of “unclean hands.”

As described a few years ago by Justice Emily Pines in the Kimelstein dissolution case, the unclean hands doctrine “bars the grant of equitable relief to a party who is guilty of immoral, unconscionable conduct when the conduct relied on is directly related to the subject matter in litigation and the party seeking to invoke the doctrine was injured by such conduct.”

The doctrine has been employed in dissolution cases in two ways. First, it can defeat a petitioner’s standing to seek dissolution, as in Kimelstein where Justice Pines held that the petitioner’s admitted concealment from his ex-wives, creditors and federal government of his alleged, undocumented 50% equity interest in two corporations owned by his brother barred him from asserting the requisite stock holdings to seek statutory dissolution. Second, even when the petitioner’s stock ownership is conceded, the doctrine can bar the petitioner’s dissolution claim on the merits.

The doctrine’s latter use rarely has been successful. A recent exception is Sansum v Fioratti, 128 AD3d 420 [1st Dept 2015], in which the Appellate Division, First Department, ordered the dismissal of a common-law dissolution claim brought by a 6% shareholder in an art gallery based on the plaintiff’s “embezzlement” of company funds for which he pled guilty to larceny and related charges. The decision packs an even more powerful punch by virtue of the court’s summary disposition of the claim, disagreeing with the lower court that a hearing was required and invoking the doctrine of in pari delicto (Latin for “in equal fault”) to reject the plaintiff’s counter-argument, that the defendant stockholders themselves conducted illegal business operations.

The case is ancient, having been brought in 2001 but then, apparently, stayed by the court for years pending criminal proceedings. The plaintiff’s amended complaint filed in 2007 alleged that he began working for the art gallery in 1989 and around 1996 was given a 6% stock interest. The complaint paints a picture (pun intended) of an art gallery business whose controlling owners regularly engaged in fraudulent sales and income diversion designed to avoid taxes for the owners and their customers and for which, allegedly, one of the owners and the gallery itself pled guilty to tax violations and paid over $700,000 in back taxes, penalties, and interest.

The plaintiff alleged that he resigned his employment in 2001 amidst escalating tensions with the controlling shareholders and subsequently was “locked out” of the business. His complaint asserted various claims including breach of fiduciary duty for “diminishing the value” of the business and for common-law dissolution.

In their answer, the defendants asserted plaintiff’s unclean hands as an affirmative defense and accused him of taking valuable company property when he resigned his employment, using company credit cards to pay a variety of personal expenses, using company funds to pay his own credit card bills, and giving company funds to friends and relatives.

The defendants eventually moved for summary judgment dismissing the complaint, relying principally on a series of plea agreements made by the plaintiff on charges of larceny, business records falsification and tax evasion, in which he admitted improperly using and taking company assets and funds totaling hundreds of thousands of dollars. The plaintiff responded that everything he took was sanctioned by the defendants as his employment compensation and that the defendants themselves had engaged in tax evasion and other bad-faith conduct.

In a January 2014 decision, Manhattan Supreme Court Justice Barbara Jaffe dismissed all of plaintiff’s claims except the dissolution claim, on the ground they were brought improperly as direct claims instead of derivatively. As to the dissolution claim, Justice Jaffe ruled that a hearing was required to resolve disputed factual issues, including as to the plaintiff’s alleged unclean hands. “Moreover,” the court wrote, “even if plaintiff had unclean hands, he levels the same allegation against defendants, who dispute it.”

Both sides appealed, but defendants came out on top. The appellate court not only affirmed the lower court’s dismissal of the derivative claims, it also dismissed the common-law dissolution claim based on the plaintiff’s unclean hands. The court also refused to give weight to plaintiff’s allegations concerning the defendants’ conviction for tax evasive business practices, citing the in pari delicto doctrine and writing as follows:

Plaintiff’s claims for breach of fiduciary duty and good faith and fair dealing were properly dismissed as derivative, as they turn on allegations of the individual defendants’ looting and mismanagement of the defendant corporation (see Yudell v Gilbert, 99 AD3d 108, 114 [1st Dept 2012]). Plaintiff’s sixth cause of action for common-law corporate dissolution, should have been dismissed under the doctrine of unclean hands, as plaintiff’s embezzlement demonstrated that he could not seek equitable relief (see Blue Wolf Capital Fund II, L.P. v American Stevedoring, Inc., 105 AD3d 178, 184 [1st Dept 2013]). We are not persuaded by plaintiff’s argument that defendants used unlawful means to acquire the money and property he admittedly embezzled from them. Under the doctrine of in pari delicto, “no court should be required to serve as paymaster of the wages of crime” (McConnell v Commonwealth Pictures Corp., 7 NY2d 465, 469 [1960] [citation omitted]).

It’s quite common in dissolution cases to find allegations of financial or other impropriety flying in both directions. What’s important to keep in mind, at least when the activity showing the petitioner’s unclean hands is asserted as a defense to the merits of the dissolution claim, is that the activity must be related to the grounds asserted for dissolution, i.e., it cannot be extraneous to the issues of oppression, deadlock, etc. The required nexus between the alleged misconduct and dissolution harkens back to dicta in the New York Court of Appeals’ seminal Matter of Kemp & Beatley decision where the court wrote:

The purpose of this involuntary dissolution statute [BCL 1104-a] 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]