Anti-Dissolution Provisions and Public Policy
March 14, 2022
In Congel v Malfitano, New York’s highest court wrote that business partners are free to include in partnership contracts practically “any agreement they wish,” including about “the means by which a partnership will dissolve, or other aspects of partnership dissolution.” This broad freedom of contract, the Court explained, is circumscribed only by “prohibitory provisions of the statutes,” countervailing “rules of the common law,” or “considerations of public policy.”
Two weeks ago, Peter Sluka wrote about one example of public policy prohibiting contracts among closely-held business owners: a recent decision ruling unenforceable a buy-sell provision in an LLC agreement because the contract deemed breach of any provision, no matter how minor, to be “forfeiture for a dollar,” which the Court found “grossly disproportionate,” “unreasonable,” and an “unenforceable penalty.”
This week, we’ll look at another example of public policy curtailing enforcement of agreements among closely-held business owners. A strand of a half dozen New York appellate decisions have held that contractual prohibitions on judicial dissolution proceedings – so-called “anti-dissolution” provisions – are potentially unenforceable depending on how broadly and in what manner they prohibit access to courts. We’ll summarize the state of the law at the end of this article.
In Matter of Validation Review Assocs., Inc. (223 AD2d 134 [2d Dept 1996]), the first New York appeals case to consider enforceability of anti-dissolution provisions, the Court framed the issue succinctly: “We are asked to determine the validity of a provision within a shareholders’ agreement to waive the statutory and common-law right to petition for a judicial dissolution of a closely held corporation.”
In Validation Review, a shareholders’ agreement executed by two equal shareholders, Berkun and Schimel, agreed “not to petition, and to use their best efforts to cause the directors of the Corporation not to petition, any court for the judicial winding-up or dissolution of the Corporation whether in the event of an impasse with respect to the operations of the Corporation or otherwise.” Berkun sued to dissolve for deadlock under Section 1104 of the Business Corporation Law (the “BCL”). Schimel moved to dismiss the petition as “barred by the anti-judicial dissolution provision of the shareholders’ agreement.” The Motion Court held the provision “void as against public policy.”
On appeal, the Appellate Division engaged in a lengthy discussion of judicial dissolution remedies as vital to the protection of minority shareholders’ rights. The Court held:
Here, if effect is given to the . . . shareholders’ agreement, neither Berkun nor Schimel alone may effect a voluntary dissolution . . . . Consequently, the effect of the anti-judicial dissolution provision at issue, which is absolute on its face, is to vitiate the parties’ statutory right to seek a judicial dissolution . . . regardless of whether . . . the corporation is paralyzed by deadlock or dissension to the detriment of its shareholders, or one or both of the parties are guilty of illegal, fraudulent, or oppressive conduct toward the other. Such a provision violates the public policy for the protection of shareholders as expressed by the Legislature and under the common law (citations omitted).
But the Court carefully distinguished between total and partial prohibitions on dissolution, writing, “[W]hile there is clearly no absolute prohibition against the parties entering into some form of agreement as to how the dissolution of a corporation might be effected, e.g., through buy-out provisions or an arbitration agreement, such a goal cannot be accomplished, as here, by an absolute prohibition against judicial dissolution of a corporation under any circumstances” (citations omitted, emphasis added).
Lastly, the Court left undecided the question of “[w]hether Berkun may be held liable for damages for his breach” of the anti-dissolution provision, which the Court found to be “an issue that has been raised in a related action between the parties” and not before the Court.
Validation Review happens to be the most thorough New York appeals court decision about unenforceability of anti-dissolution provisions. The irony? The Court of Appeals vacated it a year later, viewing the appeal as “academic” because of the Motion Court’s subsequent order dissolving the entity and appointing a receiver (see Matter of Validation Review Assocs., 91 NY2d 840 ). Why write about Validation Review? Read on.
Schimel v Berkun (264 AD2d 725 [2d Dept 1999]), was the “related action” mentioned in Validation Review, in which Schimel alleged damages against Berkun for alleged breach of the anti-dissolution covenant. Schimel gave the Appellate Division an opportunity to resurrect its vacated decision in Validation Review.
In Schimel, the Motion Court dismissed Schimel’s damages claims for breach, but reinstated them after the Court of Appeals issued Validation Review. On appeal in Schimel, the Appellate Division reversed, holding that “since the Court of Appeals reversed upon the ground that the dissolution proceeding had become academic, the Court of Appeals never reached the merits of the substantive issues raised by the appeals.” On the merits, the Court held, “[W]e find that the reasoning expressed in our prior decisions and orders” in Validation Review “remains persuasive authority, and we adhere to our rationale that a provision in a shareholders’ agreement which purports to prohibit judicial dissolution of a corporation violates public policy as expressed by the Legislature and under the common law.
In effect, Schimel ratified Validation Review.
Next came Teeter v De Lorenzo (275 AD2d 528 [3d Dept 2000]), a case involving four general partners.
In Teeter, paragraph 23 of the partnership agreement “prohibited any partner from making a judicial dissolution application.” Two partners sent written notice “dissolving the partnership, effective immediately.” A year later, when the partners could not agree how to wind down the business, the withdrawn partners sued for a “judgment declaring the partnership to be dissolved.” The two non-withdrawn partners “counterclaimed for damages for plaintiffs’ breach of paragraph 23.” The Court ruled, “It is clear that the partnership had no definite term and, therefore, was terminated by plaintiffs’ letter” dissolving the partnership “without breaching the partnership agreement.”
The Teeter Court also held that the partnership dissolved by operation of law under Section 62 (1) (b) of the Partnership Law when the plaintiffs withdrew – before plaintiffs sued to declare it dissolved – so they did not breach the partnership agreement’s anti-dissolution provision. The Court held, “We concur in Supreme Court’s implicit rejection of defendant’s argument that plaintiffs’ instant action, brought after the termination of the partnership, was a violation of paragraph 23 of the partnership agreement subjecting plaintiffs to liability for breach of that agreement.”
In Matter of El-Doh Realty Corp. (48 AD3d 1190 [4th Dept 2008]), the Court considered whether a buy-sell agreement provision in a shareholders’ agreement, which was triggered upon a minority shareholder’s commencement of a dissolution proceeding under BCL 1104, functioned as an unenforceable anti-dissolution provision.
In El-Doh, the Motion Court’s opinion carefully distinguished Schimel, explaining: “The Schimel case addresses only the issue of an absolute prohibition on dissolution and expressly acknowledges the power of shareholders to employ terms to prevent a forced sale of the company. In the present matter, there is no prohibition with respect to a dissolution proceeding. If the right of first refusal is not elected by the non-offering shareholders, dissolution is available.” The Appellate Division agreed, ruling, without explanation, that enforcement of a buy-sell agreement triggered by commencement of a judicial dissolution proceeding “does not violation public policy.”
Ferolito v Vultaggio (99 AD3d 19 [1st Dept 2012]), was one of several appellate decisions in the sprawling AriZona Iced Tea litigation.
Ferolito considered whether a non-petitioning shareholder’s unilateral exercise on behalf of the corporation of a buyout election under BCL 1118 upon filing for judicial dissolution under BCL 1104-a violated a shareholders’ agreement requiring “mutual agreement” of both shareholders for “all material matters.” Citing Schimel, the Appellate Division wrote: “Statutory dissolution and election rights may be restricted (but not nullified) by contract.”
The Ferolito Court ruled that “in the absence of an explicit agreement to that effect, a shareholders’ agreement fixing the terms of a voluntary sale does not apply to limit Business Corporation Law § 1118 (a)’s absolute and unconditioned right to avoid dissolution by election” (quotations omitted). “Simply put,” the Court wrote, “a shareholder who petitions for dissolution should not have the ability to veto the corporation’s election to do so.” In effect, the Court found that strong policy reasons for enforcing the BCL 1118 buyout election trumped competing unanimity language in the shareholders’ agreement.
Lastly, in SSM Realty Group, LLC v 20 Sherman Assocs., LLC (101 AD3d 433 [1st Dept 2012]), the Court considered enforceability of an operating agreement’s provision that “each Member, in his capacity as such, hereby irrevocably waives any such right to petition for dissolution of the Company under the Act, and all similar rights under other applicable law, except to the extent such relief may be sought by the Company itself as authorized by the Members in accordance with this Agreement.”
Distinguishing Schimel, the Motion Court held that the operating agreement was not an unenforceable “complete or absolute bar to a judicial dissolution” because it “expressly permits a petition for dissolution by the LLC to the extent the Members authorize such a petition.” On appeal, though, the Appellate Division ruled that the Motion Court “should not have discussed the merits of the dispute,” and should instead have compelled arbitration under the operating agreement’s language that “[a]ny controversy or claim arising out of or relating to this Agreement shall be finally resolved by arbitration.” The Court ruled, “The issue whether an anti-dissolution provision in an LLC’s operating agreement violates public policy does not fall into the categories of matters that cannot be arbitrated.”
According to Fred Seeman, the plaintiffs’ counsel in SSM (many thanks for taking my call), the case settled before the arbitrator could decide enforceability of the anti-dissolution provision.
The Rules of Law
What general rules flow from these cases?
- First, an “absolute prohibition” on petitioning courts for judicial dissolution of a business entity is unenforceable (see Validation Review).
- Second, there is no viable cause of action for money damages for breach of an unenforceable anti-dissolution provision (see Schimel).
- Third, it is not a breach of an anti-dissolution provision to sue for a declaratory judgment that an entity dissolved because of an event of dissolution occurring pre-lawsuit (see Teeter).
- Fourth, mandatory buy-sell or right-of-first-refusal provisions triggered upon commencement of a judicial dissolution proceeding are not considered unenforceable anti-dissolution provisions (see El Doh).
- Fifth, the law of (un)enforceability of anti-dissolution provisions applies by analogy to contractual prohibitions or restrictions on BCL 1118 buyout elections (see Ferolito).
- Sixth, the question of enforceability under public policy of a contractual anti-dissolution provision is arbitrable (see SSM Realty).
Contrary Delaware Law
How do Delaware courts view this subject?
In R & R Capital, LLC v Buck & Doe Run. Val Farms, LLC (Mem. Opinion, Civ. No. 3803-CC [Del Ch Aug. 19, 2008]), the Court held enforceable an operating agreement’s provision in which the members agreed that “irreparable damage would occur if any member should bring an action for judicial dissolution of the Company,” and that each member “waives and renounces such Member’s right to seek a court decree of dissolution or to seek the appointment by a court of a liquidator for the Company.”
The Court ruled that “Delaware is a freedom of contract state” and that the LLC Act contains specific provisions that “cannot be waived,” judicial dissolution not among them.
The Court also ruled that Delaware law imposes upon all LLCs “the implied covenant of good faith and fair dealing,” so, in the Court’s opinion, no “[t]here is no threat to equity in allowing members to waive their right to seek dissolution, because there is no chance that some members will be trapped in a limited liability company at the mercy of others acting unfairly and in bad faith.”
It will be interesting to see if any future litigants rely upon R & R in a New York litigation. If any of our readers have done so, please let us know.