RutledgeThe business community’s growing preference for the LLC entity form over the traditional corporation and partnership forms has introduced a whole new set of planning issues for lawyers who counsel clients at the formation stage in preparing the new LLC’s constitutional documents, including most importantly the operating agreement.

Tom Rutledge (photo right), one of the nation’s leading experts on LLCs and a principal drafter of his home state of Kentucky’s LLC Act among his many other accomplishments and leadership roles in the field of business organizations, recently published an article in the Journal of Passthrough Entities on the hot-button topic of LLC member expulsion with the provocative thesis that counsel need to actively consider and draft operating agreements that authorize forced expulsion of a member under specified circumstances in order to protect the venture’s ongoing activities and viability. The article is entitled “It’s Not Me, It’s You: Planning for Expulsion of LLC Members” and you owe it to yourself to read it here.

The article addresses the statutory backdrop for member expulsion; the grounds for expulsion to consider including in the operating agreement; the voting prerequisites and procedure for effectuating expulsion; the effect of expulsion including buy-out; and judicial review of expulsion decisions.

After reading the article, I asked Tom if he would discuss LLC member expulsion on my Business Divorce Roundtable podcast. I’m happy to report that Tom obliged, and you can hear my interview of Tom by clicking on the link at the bottom of this post.

The interview covers not only LLC member expulsion pursuant to the operating agreement which is the subject of Tom’s article, but also judicial expulsion of LLC members, a topic that recently generated headlines (and a post on this blog) when the New Jersey Supreme Court earlier this month issued its decision in IE Test v Carroll reversing an order of judicial expulsion under that state’s LLC Act. Judicial expulsion is destined to take on greater importance and controversy as more states adopt the Revised Uniform LLC Act which authorizes courts to expel an LLC member at the behest of the company or the other members on grounds involving breach of the operating agreement or other misconduct, or because it’s not reasonably practicable to carry on the business of the LLC with the member whose expulsion is sought.

There’s much more food for thought in Tom’s article and the podcast interview. I urge you to read and listen to both.

Good faithIf, as appears likely, the drafters of the LLC membership interest repurchase provisions at issue in Saleeby v Remco Maintenance, LLC, 2016 NY Slip Op 31447(U) [Sup Ct NY County July 25, 2016], thought they were helping the company avoid the possibility of litigation over the value assigned to the outgoing member’s interest, as it turns out they were sorely mistaken.

Poorly drafted or not, the LLC’s managers also likely did themselves and the company no favor by assigning a zero-dollar value to the membership interest of the terminated member in the Saleeby case, and by muddling the timing of the company’s exercise of its repurchase option.

Here, in a nutshell, is what happened in Saleeby as described in Manhattan Commercial Division Justice Anil C. Singh’s decision: In 2005, the defendant company Remco Maintenance, a New York based Delaware LLC, hired plaintiff Saleeby as its President and CEO. Saleeby’s employment agreement granted him a 7.5% Class B membership interest which fully vested by the time he was terminated without cause in February 2012. Over the next two years, Saleeby and the company attempted without success to negotiate their dispute over his termination, severance, vacation pay, and rights to unemployment insurance. In 2014, the company informed Saleeby that in 2013 it had exercised its option under the LLC Agreement to repurchase his membership units at a “fair market value” of zero dollars. Saleeby subsequently filed suit against the LLC for breach of contract and conversion. Continue Reading Good Faith Trumps Sole Discretion in LLC Agreement’s Repurchase Provision

ExpulsionThere are arguments pro and con when it comes to the power to expel a/k/a dissociate an LLC member. On the one hand, expulsion can be viewed as a necessary measure to preserve the LLC as a going concern when faced with persistent misconduct or failure to perform by one of its members. On the other hand, depending how broadly or narrowly the expulsion criteria are drawn, the power to expel can be a tool of oppression and abuse by those wielding it for their self-advantage.

Expulsion can occur in one of two ways. First, the operating agreement can authorize member expulsion under specified circumstances by self-executing action of the other members or managers. This is not a feature I regularly come across in operating agreements of LLCs, especially those whose membership consists of founding owners actively involved in the business.

Second, in states that have adopted the Revised Uniform LLC Act — to date numbering 16 plus the District of Columbia; New York is not one of them — courts are authorized to expel an LLC member on application by the company or a member on three specified grounds, two of which entail fault-based standards based on intentionally wrongful conduct or material breach, and the third of which dispenses with the notion of wrongful conduct by authorizing judicial expulsion of a member who

has engaged or is engaging in conduct relating to the company’s activities and affairs which makes it not reasonably practicable to carry on the activities and affairs with the person as a member.

Not surprisingly, the open-endedness of the above provision when utilized in LLC disputes has generated litigation, with New Jersey courts taking the lead. Last week, in IE Test, LLC v Carroll, 2016 WL 4086260 [NJ Sup Ct Aug. 2, 2016], that state’s Supreme Court handed down a major decision in which it reversed the lower courts’ summary judgment order expelling an LLC member and adopted a series of factors to assist trial courts in determining whether it is not reasonably practicable to operate an LLC in light of a subject member’s conduct. Continue Reading New Jersey Supreme Court Raises the Bar for Judicial Expulsion of LLC Members

consentThe pick-your-partner principle is universally embedded in the default rules of limited liability company enabling acts, including Sections 601 through 604 of the New York LLC Law which permit free assignment of distributional and other economic rights appurtenant to a membership interest but require the other members’ consent before an assignee is granted full member status with voting and other rights associated with membership in an LLC.

The distinction between a “mere” assignee versus a transferee with member status can become a battle ground when a putative LLC member who received his, her or its interest by assignment brings legal action against the LLC’s managers for dissolution, access to books and records, or asserting derivative claims on behalf of the LLC. That’s because by statute and/or common law, the suing party’s requisite legal standing to assert such claims depends on having member status.

A recent decision by Manhattan Commercial Division Justice Saliann Scarpulla in MFB Realty LLC v Eichner, 2016 NY Slip Op 31242(U) [Sup Ct NY County June 24, 2016], in which she dismissed derivative claims by a mere assignee of LLC interests, starkly illustrates the distinction and the importance of compliance with the LLC agreement’s provisions for bestowing member status on assignees. Continue Reading Operating Agreement’s Two-Step Consent Provision Foils Assignment of LLC Member Interest

The tiny state of Delaware plays an enormous role in this country’s corporate life. Delaware has long been the overwhelmingly preferred state of incorporation for publicly owned companies, and its cutting-edge (many would also say pro-management) enabling acts for closely held business entities have made it an exporter to the other 49 states of countless privately owned corporations, limited partnerships, and limited liability companies that have no connection to Delaware other than their state of formation.

The Delaware judicial system serves an integral role in maintaining the state’s corporate hegemony. The Delaware Court of Chancery is widely viewed as the country’s preeminent business-law trial court by virtue of its broad jurisdiction over Delaware business entities both public and private, and thanks to a judicial selection process that promotes the best and brightest candidates for the court’s judgeships including one Chancellor and four Vice-Chancellors whose typically thorough and scholarly written opinions are closely followed by lawyers and judges throughout the country.

Business divorce practice nationwide is no less susceptible to the influence of the Delaware legislative and judicial juggernaut. In New York, as in other states that are home to many Delaware-formed business entities, the internal affairs doctrine mandates application of Delaware law to disputes among entity co-owners, and jurisdictional constraints require owners seeking the ultimate remedy of judicial dissolution to do so in the Delaware Chancery Court. The Chancery Court’s interpretation of Delaware business entity statutes governing internal relations among co-owners of closely held business entities also has had significant influence over the interpretation of counterpart statutes in other states by their judiciaries. (A prominent example of this is the Second Department’s 2010 decision in the 1545 Ocean Avenue case which drew heavily upon Delaware Chancery Court precedent in setting the standard for judicial dissolution of LLCs under Section 702 of New York’s LLC Law.)

HeymanLadigAll of which is why I’m excited to invite readers to listen to my most recent podcast episode on the Business Divorce Roundtable entitled “Business Divorce, Delaware Style” featuring my interview of two leading Delaware litigators — Kurt Heyman (photo left) and Pete Ladig (photo right) — talking about what it’s like to litigate business divorce cases in the Chancery Court and current developments in Delaware law affecting such cases including important decisions I’ve written about on this blog in the TransPerfect, Carlisle, and Meyer cases.

Click on the link at the bottom of this post to hear the interview.

Kurt Heyman is a founding partner of Proctor Heyman Enerio LLP in Wilmington, Delaware, where he focuses his practice on corporate governance, partnership and limited liability company disputes in the Delaware Court of Chancery. Kurt lectures and writes extensively on business divorce and other corporate governance topics, he’s Co-Chair of the Business Divorce Subcommittee of the ABA Business Law Section, and he leads the Business Divorce and Private Company Disputes group on LinkedIn.

Pete Ladig is Vice Chair of the Corporate and Commercial Litigation Group at Morris James also in Wilmington. Pete concentrates his practice in the areas of corporate governance and commercial litigation, stockholder litigation, fiduciary duties, partnership and limited liability company disputes, and class action and derivative litigation. He’s also active in the ABA Business Divorce Subcommittee and has published articles on business divorce topics including a must-read post on his firm’s blog called What Is Business Divorce? Pete also co-hosts a podcast called CorpCast discussing corporate and commercial law in Delaware.

If you’re interested in business divorce, you’ll certainly enjoy listening to my interview of Kurt and Pete, both of whom speak on the subject with great authority, insight, and passion.

tie-breakerThe New York Business Corporation Law offers the 50% shareholder of a close corporation two avenues to judicial dissolution: deadlock at the board or shareholder level or internal dissension under BCL § 1104, and oppressive actions by the directors or those in control of the corporation under BCL § 1104-a.

The 50% petitioner faces an important strategic decision whether to invoke one or the other (or both) of the statutes. That’s because § 1104-a — but not § 1104 — triggers the respondent’s elective right under BCL § 1118 to acquire the petitioner’s shares for fair value. As I’ve written previously, often a 50% petitioner may gain greater negotiating leverage by proceeding solely under § 1104 based on deadlock, thereby depriving the other 50% faction of a statutory buy-out opportunity.

I can only speculate whether a strategic decision of that sort was at work in Matter of Hudson (Pure Lime USA, Inc.), Short Form Order, Index No. 600127/16 [Sup Ct Nassau County June 16, 2016], in which Nassau County Commercial Division Justice Stephen A. Bucaria dismissed the 50% shareholders’ § 1104 dissolution petition that superficially asserted director deadlock, but where the governing shareholders agreement authorized one of the respondent’s designees on the four-member board to cast the deciding vote in case of a tie vote. How can there be deadlock, the winning argument went, when the parties had a tie-break provision specifically designed to avoid deadlock? Continue Reading Tie-Breaker in Shareholders Agreement Defeats Deadlock Dissolution Petition

CunninghamNew Hampshire lawyer John Cunningham eats, sleeps and breathes limited liability companies.

Seriously, John has carved out for himself a niche practice as one of the foremost experts in the country on the formation of limited liability companies and the drafting of LLC operating agreements.

He shares his knowledge through his many lectures and publications, including his leading LLC formbook and practice manual, co-authored by Vernon Proctor, called Drafting Limited Liability Company Operating Agreements published by Wolters Kluwer, and his highly informative blog Cunningham on Operating Agreements. John also chaired the committee that wrote the New Hampshire Revised LLC Act enacted in 2013.

From a business divorce perspective, management deadlock is a recurrent problem and precipitator of litigation for LLCs with two equal members. I didn’t fully grasp the potential magnitude of the problem, however, until I read John’s recent article in the Wealth Counsel Quarterly called “Avoiding Deadlocks in LLC Operating Agreements” in which he cited an IRS statistic that 25% of all LLCs nationwide consist of two members. My own experience jibes with John’s article’s observation, that “the members of most two-member LLCs are equal in voting and profit shares,” and that

For all of these LLCs, the issue of deadlock is major. Even in the best two-member LLC, it is likely that deadlock issues will eventually arise, and can destroy an otherwise promising LLC.

Continue Reading John Cunningham on Avoiding Deadlock in Two-Member LLCs

Not VerifiedIn one of my first posts on this blog I warned about the dire consequences (i.e., dismissal) of bringing a summary proceeding for corporate dissolution under Article 11 of the Business Corporation Law by filing a petition verified by the petitioner’s attorney rather than by the petitioner, unaccompanied by the petitioner’s sworn affidavit attesting to the merits of the petition’s alleged grounds for dissolution.

What about the other way around, that is, when a respondent opposing a dissolution petition files an answer to the petition verified only by his or her attorney, also unaccompanied by a sworn affidavit of the respondent attesting to the facts offered in opposition to dissolution?

Not surprisingly, the consequences are equally dire — for the respondent, anyway — as illustrated by the court’s recent decision in Matter of Salcedo (Hispanos Car Service, Inc.), 2016 NY Slip Op 31143(U) [Sup Ct Richmond County May 11, 2016], granting a dissolution petition in the absence of “admissible evidence” contradicting the petition’s allegations. Continue Reading How Not to Oppose a Dissolution Petition

Molk_Peter

Peter Molk, an Assistant Professor of Law at Willamette University College of Law and a rising young star in legal academia, has written a groundbreaking article entitled How Do LLC Owners Contract Around Default Statutory Protections? slated for publication in the University of Iowa College of Law’s Journal of Corporation Law and currently available here on SSRN.

The article also is the subject of my podcast interview of Professor Molk embedded at the bottom of this post.

Professor Molk’s article deserves attention because it asks and attempts to answer based on empirical evidence a vital question: Is the freedom of contract promoted by the LLC statutes’ default rules being used as theory would predict, to promote economic efficiency and to craft more efficient owner protections? In fact, his study finds that LLCs with more vulnerable owners adopt fewer owner safeguards, suggesting that contractual freedom may be used by LLC controllers opportunistically rather than to achieve efficiencies.

Professor Molk’s first-of-its-kind study tests theory with the reality of what is actually happening in the world of LLC operating agreements. He does this by carefully examining almost 300 operating agreements of LLCs involved in litigated cases mostly in Delaware but also in New York, looking for provisions that either weaken or strengthen owner protections granted by the statutory default rules. The patterns his study finds have a direct impact on business divorce practitioners and also should influence choice of entity decisions and the drafting of agreements by practitioners involved in entity formation.

In his own words, here’s the abstract of Professor Molk’s article:

Limited liability companies are built on the idea of contractual freedom. Unlike other business organization forms, most owner protections apply only by default to LLCs, which are free to waive or modify them as desired. This freedom promises economic efficiency if parties are sophisticated but raises the potential for opportunism by relatively more sophisticated managers and majority owners. While companies ranging from small landscape firms to Chrysler and Fidelity organize as LLCs, remarkably little is known about whether or how LLCs use this contractual flexibility.

I analyze the operating agreements of 283 privately owned LLCs organized under Delaware and New York law to determine when and how parties alter default provisions. I find widespread use of LLC statutes’ flexibility to decrease default owner protections, as well as widespread adoption of substitute owner protections that do not apply by default. There is little evidence, however, that the contractual freedom is used to craft more efficient owner protections. Instead, using a proxy for owner vulnerability, I find that LLCs with more vulnerable owners adopt significantly fewer owner safeguards, suggesting that contractual freedom may be used more for opportunism, not efficiency.

Professor Molk has much, much more to say on the subject in my podcast interview which I hope you’ll listen to and enjoy.

 

WillThere’s been very little case law defining the powers of the executor of a deceased LLC member under New York LLC Law § 608, enabling the executor or other estate representative to “exercise all of the member’s rights for the purpose of settling his or her estate or administering his or her property, including any power under the operating agreement of an assignee to become a member.”

Perhaps the dearth of section 608 case law stems from the fact that even the most basic LLC operating agreements usually include provisions governing the disposition of a deceased member’s interest.

For example, the agreement may trigger mandatory redemption or buy-out of the deceased member’s interest. Or, as in the Budis case, it may track the default rules under sections 603 and 604 permitting the assignment of LLC interests to any person who, unless admitted as a member by the surviving members, obtains only an assignee’s right to receive the distributions and allocations of profits and losses the deceased would have received, i.e., receives no voting rights and therefore lacks member standing to participate in management, seek judicial dissolution, sue derivatively, demand access to books and records, etc.

A case from neighboring Connecticut may help to fill in at least some of the gaps in New York’s section 608 case law. A decision last month by the Appellate Court of Connecticut — that state’s intermediate appellate court — in Warren v Cuseo Family, LLC, AC 37239 [May 3, 2016], dealt with an interesting set of facts involving the estate of the majority owner of a family-owned LLC and produced an unusual but not surprising ruling giving the executor extraordinary power as temporary receiver to wind up the LLC’s affairs in order to settle the decedent’s estate. Continue Reading Executor of Deceased Majority Member Appointed Receiver to Wind Up LLC