Revoking the Irrevocable Buyout: Aligning Equity with Due Diligence in Corporate Dissolution
Lucas, Matthew C., Albany Law Review
Judicial dissolution of a closely held corporation, the "corporate divorce," is one of the most acrimonious, expensive, and, by almost all accounts, unpopular of legal remedies available in business litigation. Modern corporate statutes tend to reflect this widely held aversion by providing courts and litigants with a variety of alternatives to ending a business's existence. The buyout election, for example, a sort of call option patterned after common law remedies and American Bar Association ("ABA") model legislation, provides one means by which shareholders and corporations can avoid the extreme remedy of corporate dissolution by forcing complaining shareholders to sell their stock to them. But when can these electing shareholders or corporations change their minds about the decision to buy out their adversaries? Many statutes deem the buyout election "irrevocable"--but then allow a court to set it aside if it would be equitable to do so. Such a fluid notion of irrevocability presents challenges.
An electing purchaser might have second thoughts about buying a greater stake in a company for any number of reasons: a precipitous decline in business, the defection of key employees, an unexplained loss (or defalcation) of assets, an owner's death; all of which will arise in something of a no-man's-land between formal civil proceedings and private negotiations found in most statutory buyout procedures. With nothing more than the invocation of equity, courts must somehow divine whether a party ought to be allowed to withdraw an irrevocable election to purchase in a shifting landscape of evolving business conditions and competing interests. Not surprisingly, the reported rulings emanating from these disputes defy cohesive analysis. Some further clarity would be invaluable. This article explores a proposed method to hone the broad conception of equity these statutory provisions utilize into something more manageable and easier to grasp, a limitation premised on the commonly understood business term of transactional due diligence.
I. INTRODUCTION II. DEVELOPMENT OF THE MODEL STATUTORY BUYOUT ELECTION A. Common Law Origins B. The Model Act Buyout Elections III. SEARCHING FOR A STANDARD IN BUYOUT REVOCATION A. Survey of the Reported Rulings B. The Dilemma of Uncertainty IV. SHAPING t DUE DILIGENCE STANDARD FROM EQUITY A. Fundamentals of Equitable Limitations B. Components of the Vigilance Limitation 1. Awareness 2. Diligence C. Due Diligence in Commercial Transactions V. INCORPORATING A DUE DILIGENCE STANDARD INTO STATUTORY BUYOUT REVOCATIONS A. The Proposed Standard B. Reexamining the Rulings Under the Proposed Standard VI. CONCLUSION
Few areas in business litigation derive more acrimony than a lawsuit to dissolve a closely held corporation. Close corporations are often formed among family members or longtime friends and business partners, the kind of intimate relations that all too frequently carry simmering jealousies, sibling rivalries, personal grievances, real or imagined, all of which invariably become bound in subtle (or not so subtle) ways within the business's day-to-day operations and governance. (1) Bitter personality clashes between individuals can transform into heated commercial disagreements and corporate deadlock. The need to untangle these business relations may indeed be stark, but the separation itself is often freighted with ill will. As the Delaware Court of Chancery once observed, "[e]motions run high, feelings are frayed, and former friends and colleagues find themselves at odds." (2) Judicial dissolution petitions have been likened to a "corporate divorce," and not without justification. (3)
But because terminating a corporation's existence necessarily carries a profound impact on anyone connected to its business--the shareholders, employees, customers, vendors, and suppliers may all have considerable stakes, if not their entire livelihoods, invested in its viability (4)--there has arisen over time a prevailing view that, regardless of contention among the owners, involuntary dissolution of a corporate entity ought to be avoided if at all possible and reserved as a mechanism of last resort. (5) One alternative in particular that has gained a wide level of acceptance is a statutory right to purchase a complaining party's shares in lieu of dissolving the business. (6) In 1990 the ABA approved section 14.34 of the Model Business Corporations Act ("Model Act") to codify, as an alternative to dissolution from owner deadlock or shareholder oppression, a statutory framework to facilitate a shareholder's buyout. (7) To date, twenty-nine states have enacted some form of an elective purchase remedy within their respective corporate statutes, of which sixteen are patterned directly after the Model Act's section 14.34. (8)
By design, the model statute provides a straightforward mechanism to effectuate the buyout during litigation. "In a proceeding under section 14.30(a)(2) to dissolve a corporation" that has no shares listed on a national securities exchange or regularly traded in a market maintained by one or more members of a national or affiliated securities association, "the corporation may elect or, if it fails to elect, one or more shareholders may elect to purchase all shares owned by the petitioning shareholder at the fair value of the shares." (9)
Filing such an election (10) carries a number of concomitant responsibilities on the part of the electing party, the corporation, the remaining shareholders, and the court overseeing the case, which are described in both substantive and temporal terms within the statute. (11) Indeed, the entire process--including prescribed notice procedures, deadlines, a mandatory negotiation period, and the availability of a judicial valuation hearing--would appear almost mechanical in structure and operation. (12)
Yet, within this framework the drafters of the model legislation set aside a significant role for a trial court to exercise a range of equity powers. (13) Particularly noteworthy is how the buyout election, the triggering event for the entire process, is characterized in subsection (a): "An election pursuant to this section shall be irrevocable unless the court determines that it is equitable to set aside or modify the election." (14) Which raises the question, when might it be equitable to allow a party to withdraw such an offer?
It is an issue located at a dynamic intersection between statutory directives, corporate dispute resolution, and ancient common law principles of equitable jurisprudence. The relatively few reported decisions to construe this grant of authority have applied it in the broadest ways conceivable, relying on a seemingly unfettered grant of equitable powers within the legislation, but seldom have the courts offered definitive pronouncements about the contours of that authority or guidance for future tribunals to apply when faced with a shareholder recanting a buyout election. (15) Given the necessarily fluid nature of dissolution proceedings and the correspondingly flexible architecture dissolution statutes employ, this should hardly come as a surprise. Amidst the throng of offers, counter-offers, shifting interests and alliances, and competitive positioning within the litigation, the court becomes something of a bridge between a facilitator of corporate negotiations and an equitable arbiter should those negotiations fail. (16) Still, is it possible to discern some boundaries, some guiding limits, even in a field as wide as equity, for deciding when a shareholder may permissibly revoke his or her election to purchase? Can one find any constraints within the Model Act or the case law interpreting corporate dissolution statutes?
I believe, through the use of a modest legal fiction, it is eminently feasible to do so. Exercising the statutory election to purchase, like an arm's length transaction to acquire a stake in a business, ought to impose some level of "due diligence," as that term is commonly understood, on the part of the electing shareholder or corporation, absent which the decision should remain irrevocable. This article will examine how such a concept could yield some needed clarity in this area of the law and aid decision-makers confronted with a request to revoke what would otherwise be an irrevocable election. This article begins in Part II by briefly examining the development and more notable features of the statutory election to purchase mechanism, paying particular attention to the purposes underlying the seemingly contradictory notion of a potentially revocable irrevocable notice. Part III continues with an exposition of the case precedents surrounding election to purchase revocations, while highlighting points of tension that may have arisen among the reported decisions. Part IV explores the historic development of equity and the concept of due diligence in the law. Finally, Part V concludes by attempting to draw together all of these strands into a workable due diligence standard when a party seeks to revoke an election to purchase.
II. DEVELOPMENT OF THE MODEL STATUTORY BUYOUT ELECTION
From its beginning in 1950, the ABA's Model Act has steadily evolved both in its scope and in its level of acceptance. (17) Modifications to the Model Act frequently arose from developments found in reported case decisions or in academic writings, but just as often, changes would germinate when practitioners identified an unresolved problem that they perceived could be remedied by uniform legislation. (18) Not unlike the process of administrative rulemaking, the ABA Corporation, Banking, and Business Law Section's Committee on Corporate Laws (essentially, the entity charged with overseeing the Model Act) now publishes proposed amendments to the Model Act in The Business Lawyer, inviting comments for a period of time, which it then considers before adopting any proposed changes. (19) The buyout alternative to dissolution that came to be codified in the Model Act's section 14.34 would follow a similar historic arc. (20)
A. Common Law Origins
Its genesis can be found in the foment of equity jurisprudence. Courts had long been aware of the drastic and potentially harsh repercussions from terminating an ongoing business (21) and began harkening to their equitable powers to fashion relief that could provide redress for oppressive conduct or break deadlock, while preserving the corporate entity. (22) Among these tools, the judicially authorized buyout of a complaining owner's shares gradually came into prominence. (23) Although shareholder agreements containing buyout options could to some extent prospectively address disputes among owners, the very nature of the close corporation's legal being--a potentially unending, evolving web of relations among investors, each striving to achieve their own ends within an everchanging business environment--often generated circumstances beyond even the most sophisticated investor's predictive powers. (24) Complicating matters further was the inherently limited, if not nonexistent, public demand for shares in a closely held corporation; as the Massachusetts Supreme Court observed in Donahue v. Rodd Electrotype Co. of New England, Inc., there simply is no ready market to trade in a close corporation's stock. (25) Bad faith and bad blood between officers or directors would also frequently stymie self-directed efforts to negotiate a transfer in ownership. (26) Yet, in the majority of these disputes once a dissolution petition was actually filed, the litigants would eventually reach an agreement where one owner purchased the other's interest before a formal judicial decree dissolved the business. (27) Even in cases where an order of dissolution was entered, "the practical reality ha[d] been ... a buyout negotiated among the parties and a continuation of the business." (28) A judicially ordered buyout remedy, more often than not, was neither unexpected nor in many cases unwelcomed. (29)
The court's supervision was nonetheless seen as essential. Providing judicial direction within buyout deliberations furthered a number of important interests. (30) Practically speaking, it imposed some order over (and perhaps even fostered) a negotiation process that shareholders in litigation inevitably found themselves in. (31) The court's equitable involvement also discharged the judicial obligation to address potentially oppressive conduct by majority shareholders; equitable relief could bridge the gap between unanticipated or unlawful circumstances, on the one hand, and reasonable shareholder expectations, on the other. (32) In short, judicial management would strive to yield "the most efficient, least acrimonious, and most likely method to achieve a fair result" for everyone involved. (33)
Statutory enactments both followed and propelled the broader acceptance of equitable buyout remedies, as Professor Robert Thompson commented:
After Donahue ... the pace of legislative and judicial protection for minority shareholder[s] increased dramatically. Also important to the effective development of the oppression remedy was the development of a consensus that a buyout was the appropriate remedy when oppression had been shown. Again this was a combined result of legislative changes and judicial interpretations reflecting the legislative purpose in providing a judicial remedy that Kemp & Beatley recognized. (34)
B. The Model Act Buyout Election
With this backdrop, section 14.34 of the Model Act was formally adopted by the ABA in 1990. (35) The published commentary accompanying section 14.34 of the Model Act reflects the Committee on Corporate Laws' recognition of the historic development of buyout alternatives, as well as a basic truth that had come to be understood about judicial dissolution of corporations: the extreme remedy was "rarely necessary." (36) Section 14.34's adoption was thus motivated more from a perceived need to impose structured oversight for a process than from a desire to create any novel remedies for shareholder dissent. While laboring to fashion a workable statute, the drafters never strayed far from the equitable moorings that anchored this body of law. (37) For example, under the finalized act, once an election is filed, the dissolution lawsuit cannot be discontinued or settled and the petitioning shareholder cannot transfer his or her shares, "unless the court determines that it would be equitable" to permit it; in a valuation hearing, the court must "determine the fair value of the [petitioning shareholder's] shares as of the day before" the petition was filed, or any other date "as the court deems appropriate under the circumstances;" after deciding the shares' value, the court's order must direct their purchase on "terms and conditions as the court deems appropriate"; and, of course, the notice of election itself is "irrevocable unless the court determines that it is equitable" to modify it or set it aside. (38)
This infusion of equity and fairness marks the balance the Model Act attempted to make within its dissolution alternatives between procedural structure and equitable relief. (39) It also reflects a merger of two ideals underlying these provisions in general, the freedom of alternative dispute resolution with the protection of judicial oversight. (40) A model statute could never address every potentiality, to be sure--the fair valuation process, to take one example, has generated a chorus of conflicting views (41)--but that same ambiguity would also lend to the overall process the flexibility needed to accomplish the statute's goals. (42)
However, at the same time the Model Act sought to structuralize an amorphous process by including an election to purchase provision, that alternative opened wide another door of potential uncertainties:
Plainly, the election raises risks and strategic considerations for all parties. For the plaintiff shareholder, filing a complaint, in effect, grants a "call" to the corporation and the other shareholders--an obligation to sell, even if the plaintiff might prefer a different outcome, such as continued share ownership with a judicial order compelling a dividend. The plaintiff cannot discontinue the litigation or dispose of the shares outside of the statutory process without the court's permission. Moreover, the amount of the "fair value" is still to be determined. For the majority shareholders, electing to buy has the benefit of certainty regarding type of remedy. It eliminates the possibility that a court will ultimately grant injunctive relief or dissolution. It reduces the expense, delay, and antagonism inherent in fully litigating the issues of oppression. The principal detriments are that the irrevocable decision to purchase must be made without knowing the cost, and that the "fair value" subsequently determined by the court will not include discounts for either lack of marketability or minority status. (43)
Apart from the predictive concerns, an elective buyout option also invited a more sinister externality. Courts allowing shareholder buyouts in lieu of dissolution had long decried gamesmanship on the part of the electing shareholder or corporation. (44) The election to purchase could provide an avenue for a viable business to endure a shareholder's petition to dissolve its existence, but it could also be used by the corporation or its majority owners as a "potent weapon to temporarily silence" that same shareholder, leaving them free to continue with the allegedly oppressive conduct that may have given rise to the dissolution action in the first place. (45) The fear was not unfounded; a majority ownership still in control of the business's assets could, in theory, protract the entire process to the point of breaking the minority shareholder's means, only to renege on its offer to buy the petitioner's shares. (46)
Recognizing this potential for abuse, the drafters of section 14.34 made the election to purchase irrevocable, and at the same time prohibited the petitioning shareholder from discontinuing or settling the dissolution proceeding. (47) The link between these two prohibitions is clear from the Model Act's official commentary: "These …
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Publication information: Article title: Revoking the Irrevocable Buyout: Aligning Equity with Due Diligence in Corporate Dissolution. Contributors: Lucas, Matthew C. - Author. Journal title: Albany Law Review. Volume: 75. Issue: 1 Publication date: Fall 2011. Page number: 15+. © 1999 Albany Law School. COPYRIGHT 2011 Gale Group.
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