cash registerAppellate case law in New York generally prohibits use of company funds to pay for legal defense costs in judicial dissolution proceedings.

The theory supporting the prohibition, as articulated over 50 years ago in Matter of Clemente Brothers, 19 AD2d 568 [3d Dept], aff’d, 13 NY2d 963 [1963], is that the statute authorizing dissolution proceedings “grants to the corporation as a separate entity no authority to determine whether a proceeding shall be initiated to dissolve itself,” thus making the corporation a proper jural party “for the limited and passive purpose of rendering it amenable to the orders of the court” and barring it from assuming a “militant alignment on the side of one of two equal, discordant stockholders.”

The principles animating Clemente and its progeny such as Matter of Rappaport, 110 AD2d 639 [2d Dept 1985], and Matter of Boucher, 105 AD3d 951 [2d Dept 2013], involving deadlock dissolution proceedings between 50-50 shareholders, have been extended to cases brought under the separate statute enacted in 1979 providing a dissolution remedy for oppressed minority shareholders.

Witness Matter of Penepent Corp., 198 AD2d 782 [4th Dept 1993], where the court affirmed an order restraining the majority shareholder from using corporate funds to pay attorney’s fees in a dissolution proceeding brought by a minority shareholder under Business Corporation Law § 1104-a, and the very recent Second Department decision in Kassab v Kassab, which I wrote about here, where the court affirmed an order holding in contempt the 75% owner of two real estate holding companies — one of them an LLC, the other a close corporation — for using company funds to defend the 25% owner’s dissolution proceeding.

The First Department’s 1985 decision in Matter of Public Relations Aids, Inc., 109 AD2d 502, introduced a partial exception to the prohibition in minority shareholder oppression cases, allowing the majority’s use of company funds for legal fees but only after an election is made to purchase the petitioner’s shares under Business Corporation Law § 1118, explaining as follows:

[I]n the usual dissolution proceeding, where the corporation appears as a nominal party and the proceeding amounts to a dispute between the shareholders, corporate funds may not be used in payment of counsel fees for the individual shareholders. Here, however, there appears to be merit to [the majority shareholder’s] claim that, inasmuch as he had already exercised his buy-out option under Business Corporation Law § 1118, all that remains is a determination of the fair value of [petitioner’s] stock, and once that is made, he will be the beneficial owner of all of the corporate stock. Therefore, it may be found that, as to the period after [petitioner’s] exercise of the buy-out option under Business Corporation Law § 1118, there was no impropriety in his use of corporate funds to pay his own legal expenses. Corporate funds could not, however, be properly used to pay his counsel fees incurred prior to that election.

Prohibition Extended to Common-Law Dissolution Cases

In a decision of apparent first impression, Nassau County Commercial Division Justice Stephen A. Bucaria last month ruled that the defendant majority shareholders in an action brought by a minority shareholder seeking not statutory but common-law dissolution likewise were barred from using company funds to pay for their legal defense.

Justice Bucaria’s decision in Erickson v Erickson, Short Form Order, Index No. 608315/15 [Sup Ct Nassau County Apr. 19, 2016], involved a plumbing company owned equally by three shareholders including two brothers. After a falling out, Brother #1 filed suit against Brother #2 and the third shareholder asserting claims for common-law dissolution, an accounting, and injunctive relief. The complaint also named the corporation as a “necessary” party defendant against which no relief was sought beyond dissolution.

Soon after Brother #1 filed the lawsuit, he learned that Brother #2 drew a $10,000 check on the company account payable to an attorney who entered an appearance on behalf of Brother #2 and the corporation. Brother #1 subsequently filed a motion to enjoin Brother #2 from using company funds to pay his legal fees, directing Brother #2 to repay the $10,000 to the company, and to disqualify defense counsel from representing the company based on alleged conflict of interest and because his retention was not authorized by the Board of Directors.

Brother #1’s argument to prohibit Brother #2’s use of company funds relied on the appellate rulings in statutory dissolution proceedings. Brother #1 also contended that the complaint’s allegations of fiduciary transgressions by Brother #2 created a conflict with the company’s best interests requiring the company to have its own counsel.

In opposition, Brother #2 denied any conflict between his own and the company’s interests, accused Brother #1 of bringing a “tactical” disqualification motion, defended his use of company funds for legal fees on the ground the expenditure was for a proper business purpose, and also challenged his brother’s motion as an attempt “preemptively” to defeat Brother #2’s statutory indemnification rights as an officer and director.

Justice Bucaria’s analysis focused on whether the precedents in statutory dissolution cases cited by Brother #1 should apply in a case of common-law dissolution. “For certain purposes,” he began, “it is significant whether a minority shareholder has commenced a statutory or common law dissolution proceeding” such as, in the former, the statutory buy-out election under BCL § 1118. “Nevertheless,” he continued, “even under common law dissolution, a buy-out of the minority shareholder’s interest at fair value, may be directed by the court as an appropriate remedy.”

In the end, Justice Bucaria decided that:

[w]hile the form of the dissolution petition is significant for purposes of a buy-out election, defendants have not established that a different rule should apply for purposes of reimbursement of defense costs. Accordingly, plaintiff’s motion for an order restraining defendant [Brother #2] from using the funds of [the company] to defend this action is granted. Defendant [Brother #2] is directed to repay [the company] within five days of service of a copy of this order.

Justice Bucaria also denied without comment the branch of Brother #1’s motion to disqualify defense counsel from concurrently representing Brother #2 and the company.

In litigation among co-owners of closely held business entities, the ability of the side that controls the company checkbook to draw upon company funds to pay their litigation expenses — effectively forcing the non-controlling side to subsidize the controllers’ legal costs in addition to paying their own legal fees — can have a dramatic impact on the litigants’ relative staying power and therefore the outcome of the case whether by way of adjudication or settlement. Erickson follows the trend of court decisions taking the tilt out of the playing field.