Another Door Closes to Federal Court in Judicial Dissolution Cases

Farrell Fritz, P.C.

Not for the first time (see herehere, and here ), I find myself intrigued by the federal courts’ resistance to hearing state law claims for judicial dissolution of business entities where subject matter jurisdiction otherwise exists based on diversity of citizenship.

The doctrinal device employed by federal courts to dismiss dissolution claims (without prejudice to re-filing in state court) is called Burford abstention based on a 1943 Supreme Court case of that name. The doctrine holds that a federal court sitting in diversity jurisdiction should abstain from deciding the case to avoid needless disruption of state efforts to establish coherent policy in an area of “comprehensive state regulation.”

The leading precedent in the Second Circuit U.S. Court of Appeals (which includes federal courts in New York) is Friedman v Revenue Management, Inc., 38 F3d 668 [2d Cir. 1994], where the court applied Burford abstention to dismiss a complaint seeking judicial dissolution of a New York corporation under Section 1104 of the Business Corporation Law based on shareholder deadlock. As Friedman explained:

Under these circumstances, abstention would avoid needless interference with New York’s regulatory scheme governing its corporations. New York has a strong interest in the creation and dissolution of its corporations and in the uniform development and interpretation of the statutory scheme regarding its corporations.

Since Friedman, federal trial courts in New York (and most other federal circuits) uniformly have abstained from adjudicating  statutory dissolution claims.

But what about common-law dissolution claims? Under the leading New York case, Leibert v Clapp, 13 NY2d 313 [1963], common-law dissolution is available where:

the directors and majority shareholders ‘have so palpably breached the fiduciary duty they owe to the minority shareholders that they are disqualified from exercising the exclusive discretion and the dissolution power given to them by statute.”’

The test for common-law dissolution essentially requires courts to apply fiduciary standards to alleged misconduct by company controllers. Federal courts in diversity and federal question cases routinely hear and decide common-law claims for breach of fiduciary duty. Should fiduciary-based, common-law dissolution claims be treated differently, as part of New York’s “regulatory scheme governing its corporations,” such that Burford abstention applies?

Busher v Barry

The question of first impression was addressed by S.D.N.Y. District Judge Nelson S. Roman in Busher v Barry, No. 14-cv-4322 (NSR) [SDNY Dec. 18, 2019], a diversity suit pitting a Westchester golf club against shareholders of the corporation that owns and leases to the club the highly valuable land on which the club operates.

The Winged Foot Golf Club was formed in the 1920s as a non-profit membership corporation. Members were required to own shares in the separate realty holding entity organized as a stock corporation, such that for many years afterward membership in the club was coextensive with ownership in the stock corporation. The original lease provided for 21-year renewal terms. By the time of the 1947 lease, the club’s annual rent was capped at $30,000.

In the decades that followed, for various economic and other reasons, membership in the club and ownership in the realty corporation diverged, including the transfer of substantial ownership in the realty corporation to the club as members departed or died. The $30,000 annual rent cap remained in place through successive 21-year renewals.

The plaintiffs in this derivative shareholders action, seeking hundreds of millions in damages based on the property’s development value, inherited their shares in the realty corporation from an original club member and realty corporation shareholder.

The complaint, as whittled down by prior court rulings, primarily alleges that the controllers of the club and realty corporation breached fiduciary duties owed to the realty corporation and its shareholders by renewing the lease in 2013 for another 21-year term with the $30,000 cap in place. By doing so, plaintiffs contended, the controllers deprived shareholders of any return on their investment and, in essence, improperly treated the realty corporation as a non-profit corporation for the golf club’s benefit.

In addition to fiduciary breach, the plaintiffs’ complaint asserts claims for violation of New York Business Corporation § 720, unjust enrichment, and common-law dissolution of the realty holding corporation.

The District Court’s opinion handed down last month decided a slew of in limine motions by both sides concerning the admission at trial of numerous documentary exhibits and expert testimony.

Citing Burford abstention precedent, the golf club’s brief (read here) argued that the plaintiffs were attempting to use a “jurisdictionally-barred” common-law dissolution claim to introduce evidence precluded by the court’s previous statute of limitations ruling.

The plaintiffs’ opposing brief (read here) countered that the club’s “unexcused delay in proposing abstention” until shortly before trial “waived their right to do so” and that, in any event, the court should not abstain. Specifically, plaintiffs reasoned that common-law dissolution “is not a creature of statute but an alternative to statutory dissolution.” According to plaintiffs,

the New York Court of Appeals created common-law dissolution, as a matter of “judicial sponsorship,” to give courts the flexibility to dissolve a corporation when there is no basis for doing so under the [Business Corporation Law]. Friedman and other abstention cases cited by Defendants are inapposite to such a judicially-created remedy. The flexibility inherent in the dissolution remedy created by the Court of Appeals belies the notion that it should be restricted by limitations that arise from statutory roots. [Citation omitted.]

The Court Abstains

Judge Roman begins his analysis by noting the three factors that courts consider under Burford generally:

  • the degree of specificity of the state regulatory scheme;
  • the need to give one or another debatable construction to a state statute; and
  • whether the subject matter of the litigation is traditionally one of state concern.

Quoting from Friedman, he next offers that “[a] claim for judicial dissolution implicates Burford, ‘given the comprehensive regulation of corporate governance and existence by New York'”; that “[t]he Second Circuit has explicitly recognized that ‘New York has a strong interest in the creation and dissolution of its corporations”; and that “district courts within this Circuit have routinely, and almost uniformly, elected to exercise Burford abstention over claims for the dissolution of a corporation formed under state law.”

Under these principles, Judge Roman concludes,

the Court finds it proper to abstain from exercising that power. [The realty holding corporation], a corporation formed under the laws of the state of New York, is a creature of the state, and its dissolution necessarily implicates New York’s comprehensive system of corporate governance. The fact that Plaintiffs say they are pursuing a claim for dissolution under common law, rather than a state statute, (see Pls. Opp. 4 at 15), does nothing to alter this fact, or New York’s “strong interest in the creation and dissolution of its corporations.” Friedman, 38 F.3d at 671. Moreover, the Court is unpersuaded by Plaintiffs’ argument that Defendants have waived the right to seek the Court’s abstention. (See Pls. Opp. 4 at 13-14.) While the Court does not endorse Defendants’ delay in raising this issue, Plaintiffs have demonstrated neither that waiver of Burford abstention is a recognized concept in this Circuit, nor that they would be prejudiced by the Court’s exercise of abstention at this phase in the proceedings. Indeed, Plaintiffs admit that “[i]f the Court abstained from exercising jurisdiction over the dissolution claim, Plaintiffs would be able to re-file the cause of action in New York Supreme Court, Westchester County.” (Pls. Opp. 4 at 14 n.18.)

Should Burford Apply to Dissolution Claims?

A recent article in the NYU Law Review, entitled Burford Abstention and Judicial Policymaking, argues that the lower federal courts have extended the Supreme Court’s Burford jurisprudence beyond its roots as a limitation on “federal judicial disruption of states’ important and complicated administrative, not judicial, schemes,” and that Burford abstention at least originally required more than just an important state question.” The article also notes that “extending abstention to common law actions is particularly problematic.”

It’s certainly debatable whether core Burford abstention doctrine should apply to statutory judicial dissolution cases much less to  common-law dissolution cases. Both forms of judicial dissolution invoke the court’s discretionary equitable powers in deciding whether the circumstances merit the corporate death sentence. The broadly stated, statutory criteria of deadlock, oppressive conduct, and internal dissension are left to the courts to define and apply on a case-by-case basis.

While it’s inarguable that the state has an interest in the formation and dissolution of corporations formed under its laws, it’s less clear that federal court adjudication of dissolution claims would disrupt the state’s interest and its administrative processes any more so than many other types of state law claims affecting the life and death of state law entities that are routinely litigated in federal courts.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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