An important appellate decision handed down earlier this month holds that LLC members’ fiduciary duties to each other do not expire upon the de facto termination of the members’ business relationship, but, rather, continue until formal voluntary or involuntary dissolution. As a result, members who continue to do business through the old LLC, or who start up a new competing company prior to formal dissolution of the old LLC, must account to the excluded members for pre-dissolution profits.
The case, Matter of Beverwyck Abstract, LLC, 53 AD3d 903 (3d Dept 2008), has its genesis in a business arrangement between the two individual owners of real estate and mortgage brokerage firms (I’ll refer to them as the Brokers) and an Attorney who owned a title abstract firm called Gateway Title Agency, LLC. Previously, the Brokers had teamed up with a different attorney to form Beverwyck Abstract, LLC to perform title work, however that attorney soon withdrew from the firm. In September 2001, the Brokers assigned a 49% membership interest in Beverwyck to Gateway, with the understanding that the Brokers’ mortgage company would refer title work to Gateway. Beverwyck had no assets at the time and Gateway made no capital contribution. The fees generated by Gateway’s title work would belong to Beverwyck and would then be distributed 1/2 to the Brokers and 1/2 to Gateway. At the same time, the Brokers would arrange for the Attorney to act as the bank closing attorney for the Brokers’ mortgage company, with those fees being retained by the Attorney.
This arrangement worked for nearly two years until a flood of mortgage refinancings referred by the mortgage company exceeded Gateway’s capacity, at which point the mortgage company stopped assigning mortgage closing work to the Attorney. The tensions grew, culminating in a February 17, 2003 meeting of the Brokers and the Attorney at which they orally agreed that Gateway and the Attorney would no longer perform title work for Beverwyck. The Brokers sent the Attorney draft forms for her to execute assigning Gateway’s interest in Beverwyck back to the Brokers effective April 1, 2003, but she never signed them. For the balance of 2003, the Brokers continued to operate Beverwyck without Gateway, employing the title services of the same attorney who had been one of Beverwyck’s original members before dropping out. In early 2004, the Brokers and this other attorney formed a new company under the name Beverwyck Abstract & Settlement Co., LLC, to perform title work referred by the Brokers’ mortgage company.
The Brokers and Gateway ultimately could not reach agreement regarding the winding up of Beverwyck’s business. In late 2003, the Brokers commenced a proceeding for judicial dissolution of Beverwyck. The court conducted a two-day bench trial in March 2005, and granted dissolution by order dated May 26, 2005. The court also ordered the parties to prepare final accountings. The two resulting accountings differed by approximately $155,000 based on the use of different accounting periods. The higher number in Gateway’s accounting included the entire period following the February 17, 2003 meeting through the formal dissolution on May 26, 2005, whereas the Brokers’ accounting stopped March 31, 2003 (the end of the quarter closest in time to the meeting).
The Brokers asked the trial court to determine the date of dissolution for accounting purposes. The Brokers contended that a de facto dissolution occurred at or shortly after the February 17, 2003 meeting by reason of the parties’ agreement that Gateway would no longer provide title work for Beverwyck. They argued by analogy to partnership cases in which courts have found from circumstantial proof of the ending of a business relationship the termination of the partnership and concurrent cessation of the partners’ fiduciary duties. In a decision dated July 11, 2007 (2007 NY Slip Op 52620[U]), Albany County Commercial Division Justice Richard M. Platkin ruled against the Brokers on the ground that “Beverwyck’s operating agreement spells out unequivocally the circumstances under which the LLC will be dissolved,” and that there had been no written agreement or vote taken to dissolve the company as the operating agreement required to effectuate voluntary dissolution. As Justice Platkin elaborated:
Since the members had bound themselves by the terms of their operating agreement, the mere cessation of referrals from [the Broker's mortgage company] to Beverwyck or the bare assertion by [the Brokers] that the company was no longer in existence was insufficient to dissolve the LLC or to relieve [the Brokers] of their fiduciary duties to the organization, since such eventualities were not listed as terminating events in the parties’ operating agreement.
The Brokers appealed the decision. Their appellate brief (read it here) pressed the argument for application to LLCs of partnership law principles whereby the partner relation and associated fiduciary duties terminate upon the declared intention of a partner to withdraw from the partnership. They argued that such intention to withdraw was further evidenced by the Attorney’s e-mail sent to the Brokers after the February 17, 2003 meeting in which she referred to the parties’ “decision to terminate our business relationship” and “our decision to go our separate ways.” Gateway’s opposing appellate brief (read it here) argued that partnership withdrawal and dissolution rules do not apply to LLCs, and that the trial court correctly applied contract principles in enforcing the provisions of Beverwyck’s operating agreement. (My thanks to the attorneys in the case, Robert Ganz and Kevin Luibrand, for providing copies of their briefs.)
The July 17, 2008, decision by the Appellate Division, Third Department, affirmed the lower court’s ruling in Gateway’s favor, stating:
We cannot agree with [the Brokers'] heavy reliance upon case law regarding the dissolution of at-will partnerships and joint ventures to support their contention that the parties’ fiduciary duties to each other as members of a limited liability company ended when they met and decided on February 17, 2003 that Gateway would no longer provide title insurance services to Beverwyck. The pertinent provisions of the Limited Liability Company Law and Beverwyck’s operating agreement provide sufficient guidance here. . . . [I]t is uncontroverted that there was no formal vote or written consent of the majority of the members to dissolve. Inasmuch as they failed to do so, [the Brokers'] argument that they could have unilaterally dissolved Beverwyck because they held a majority interest is unavailing. . . . Absent written consent or formal vote of a majority of the members, the only means of dissolution recognized by the operating agreement and applicable statute was by judicial dissolution.
The court’s decision involves only the accounting for Beverwyck. Gateway brought a separate lawsuit against the Brokers and their new title company to recover a share of the latter’s profits prior to the judicial dissolution of Beverwyck in May 2005.
The Beverwyck break-up scenario and ensuing litigation tell a cautionary tale of business expediency overtaking legal loose ends in the interregnum between the onset of hostilities and the final dissolution decree. The Brokers must be kicking themselves for not conducting a formal vote and using their 51% majority to dissolve the LLC voluntarily in February 2003. In many instances, however, there is no such easy out, e.g., because there’s 50-50 ownership or the operating agreement requires an unattainable super-majority or unanimous consent for a voluntary dissolution. In those situations, short of settlement the best solution is prompt commencement of judicial dissolution and perhaps an interim application for authorization to do business for one’s own account under a different company.