No more complaining about the absence of appellate guidance on the standard for judicial dissolution of limited liability companies under §702 of the LLC Law. Finally, almost 16 years after the cryptically-worded statute became law, the Appellate Division, Second Department, in Matter of 1545 Ocean Avenue, LLC, 72 AD3d 121, 2010 NY Slip Op 00688 (2d Dept Jan. 26, 2010), offers a carefully considered explanation of what §702 means — and what it doesn’t mean — in a decision also notable for a two-judge dissent from the majority’s disposition of the case without an evidentiary hearing.
As discussed below, the 1545 Ocean opinion’s motif is fidelity to the LLC’s operating agreement. This contract-centric approach sharply distinguishes LLC dissolution from partnership and close corporation dissolution cases in which implied fiduciary duties and untethered notions of fairness permeate the courts’ analysis. It also brings New York LLC jurisprudence closer in line with Delaware’s approach to LLC dissolution fueled by the admonition contained in §1101(b) of the Delaware LLC Act, to give “maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.”
It’s no surprise that the signed opinion’s author is Associate Justice Leonard B. Austin (pictured) who was appointed to the appellate bench in 2009 after serving ten years as trial judge in the Commercial Division of the Nassau County Supreme Court. Justice Austin’s Commercial Division caseload, among other types of business disputes, included a steady influx of judicial dissolution proceedings involving closely held corporations and LLCs. That experience undoubtedly gave him a first-hand feel for the analytical and practical difficulties posed by these cases and an appreciation of the legal and business community’s need for greater certainty in applying the broad and undefined terms of the dissolution statutes.
There’s another reason I’m not surprised by Justice Austin’s authorship. In June 2002, I wrote an article for the New York State Bar Association Journal on LLC dissolution (read it here) in which I observed that most of the few cases decided to that point freely borrowed from corporate dissolution norms applicable in cases involving oppressed minority shareholders and internal dissension. I did, however, cite a trial court decision in a case called Matter of Quinn, NYLJ Apr. 20, 2000, p. 32, col. 6 (Sup. Ct. Nassau County), as the sole example I’d found of a court, consistent with §702’s language, focusing on whether the complained-of grounds for dissolution conformed to the members’ operating agreement. The judge who decided Quinn? Justice Austin.
Now let’s examine the 1545 Ocean decision.
1545 Ocean Avenue, LLC (“1545 LLC”) was formed in late 2006 as a manager-managed LLC with two 50% members, Crown Royal Ventures, LLC (“Crown Royal”) and Ocean Suffolk Properties, LLC (“Ocean Suffolk”). Crown Royal and Ocean Suffolk entered into a written operating agreement for 1545 LLC in which Crown Royal designated its principal, John King, as one of the two managers and Ocean Suffolk designated its principal, Walter Van Houten, as the other manager.
Article 4.1 of the operating agreement contained a somewhat atypical management clause for 50-50 LLCs, authorizing “any one Manager [to] take any action permitted under the Agreement, unless the approval of more than one of the Managers is expressly required [by the Agreement].”
The two members each contributed 50% of the capital used to purchase commercial real estate located in Bohemia on Long Island. 1545 LLC’s purpose was to purchase the property, rehabilitate an existing building (Building A) and build a second building on the property (Building B) for commercial rental.
King and Van Houten agreed to solicit third-party bids for the demolition and construction work. They also agreed that Van Houten, who owned his own construction company, Van Houten Construction (“VHC”), could submit bids subject to the managers’ approval.
Ultimately VHC undertook the work on Building A, with Crown Royal later alleging that VHC did so without King’s consent whereas Ocean Suffolk contended that the two managers agreed to hire VHC when there were no bona fide third-party bids. King also claimed that VHC began the work without necessary permits, did not have the proper equipment and consequently overbilled for the work. King alleged that he agreed to pay VHC’s invoice on condition that it would cease further work without King’s consent. VHC continued working on the site without King’s consent.
Tensions between King and Van Houten further escalated following a dispute over hiring a contractor for environmental remediation work. According to King, Van Houten refused to meet on a regular basis, proclaimed himself to be a “cowboy” and stated that he would “just get it done”. In April 2007, King announced that he wanted to withdraw his investment from 1545 LLC and proposed to notify all vendors that Van Houten was taking over. Van Houten viewed King as having resigned as manager. King’s attorney sent Van Houten a “stop work” demand which was ignored. The two exchanged competing buy-out proposals of each other’s interest, without resolution. Meanwhile, VHC continued to work unilaterally on the construction project which was within weeks of completion when Crown Royal sued for judicial dissolution and obtained an interim injunction preventing further work.
The Dissolution Petition
Crown Royal’s petition alleged, as the sole ground for dissolution, deadlock between the managers arising from Van Houten’s claimed violations of Article 4 of the operating agreement. The petition did not allege fraud or frustration of the purpose of 1545 LLC on the part of Ocean Suffolk, Van Houten or VHC.
Ocean Suffolk’s answer to the petition opposed dissolution and denied any violation of the operating agreement. It alleged, without dispute, that the renovation of Building A was within 3-4 weeks of completion when the litigation commenced. It also alleged that, in anticipation of a buy-out of Crown Royal’s interest, the parties had been operating as if Van Houten was sole manager. Ocean Suffolk thus contended that there could be no manager deadlock as a result of King’s resignation as manager, even though King did not submit a written resignation as required by Article 4.8 of the operating agreement.
The Lower Court’s Dissolution Order
In December 2007, the lower court issued a bare-bones order granting the dissolution petition (read it here). The order makes no factual findings, merely stating that judicial dissolution of an LLC “will be ordered only where the complaining member can show that the business sought to be dissolved is unable to function as intended, or else that it is failing financially,” and that review of the papers submitted and the conferences conducted with the court “clearly demonstrates to this Court that 1545 is unable to function as intended.”
Justice Austin’s Majority Opinion
Ocean Suffolk appealed the order of dissolution to the Brooklyn-based Appellate Division, Second Department. Justice Austin’s opinion for the 5-judge panel reverses the lower court’s order, denies the petition and dismisses the proceeding. Presiding Justice Steven Fisher, joined by Associate Justice Cheryl Chambers, wrote a partial dissent in which he would have remitted the matter to the lower court for a fact-finding hearing to determining whether Crown Royal’s petition met the newly-articulated standard for dissolution.
- The LLC Dissolution Statute Distinguished from its Corporate and Partnership Counterparts
The analysis section of Justice Austin’s opinion in 1545 Ocean, as its first order of business, tells the bench and bar what the standard for LLC dissolution is not, namely, it is not the standard developed for close corporations under the Business Corporation Law (BCL).
Upon the enactment of New York’s LLC Law in 1994, the statute contained a single section denominated §702 governing judicial dissolution of the newly recognized entity. The section provides in its entirety as follows:
On application by or for a member, the supreme court in the judicial district in which the office of the limited liability company is located may decree dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement. A certified copy of the order of dissolution shall be filed by the applicant with the department of state within thirty days of its issuance. [Emphasis added.]
As I wrote in my 2002 article on LLC dissolution, the section’s sparse language — drawn from the limited partnership dissolution statute but rarely examined in the partnership case law — created a vacuum into which many judges imported the relatively well-developed grounds for dissolution employed in cases involving close corporations under BCL §§1104 and 1104-a. It’s easy to understand why courts did so given the many similarities between, on the one hand, corporate shareholder-officers and, on the other, LLC member-managers, at least when it comes to the day-to-day realities of their internal relations and the pressures that lead to internal dissension.
Justice Austin notes that §702 was left unchanged when the LLC Law was amended in 1999 to conform to changes in federal tax treatment of LLCs (citing my 2002 article in that regard), and from that concludes:
since the Legislature, in determining the criteria for dissolution of various business entities in New York, did not cross-reference such grounds from one type of entity to another, it would be inappropriate for this Court to import dissolution grounds from the Business Corporation Law or Partnership Law to the LLCL.
He then observes that, while there is no definition of “not reasonably practicable” in the context of LLC dissolution, “[s]uch standard . . . is not to be confused with the standard for the judicial dissolution of corporations or partnerships” (citations omitted). He notes that the BCL and Partnership Law by statutory definition apply only to business corporations and partnerships, respectively, and that “[l]imited liability companies thus fall within the ambit of neither the Business Corporation Law nor the Partnership Law.” He also cites §102(m) of the LLC Law, which likewise excludes corporations and partnerships from its ambit, in concluding that “the existence and character of these various entities are statutorily dissimilar as are the laws relating to their dissolution.”
- The Court’s Articulation of the Standard for Dissolution under §702
Having told us what the statute is not, Justice Austin next turns to the central question of §702’s meaning. He notes that prior New York cases involving LLC dissolution “have avoided discussion of this standard altogether” leaving the issue unresolved. He also remarks upon the absence of case precedent construing the similarly-worded standard for dissolution under the limited partnership law.
The “not reasonably practicable” standard is linked textually in §702 to “conformity with the articles of organization or operating agreement.” This linkage leads Justice Austin to state, quite significantly, that
LLCL 702 is clear that unlike the judicial dissolution standards in the Business Corporation Law and the Partnership Law, the court must first examine the limited liability company’s operating agreement (see Matter of Spires v Lighthouse Solutions, LLC, 4 Misc 3d at 432) to determine, in light of the circumstances presented, whether it is or is not “reasonably practicable” for the limited liability company to continue to carry on its business in conformity with the operating agreement (id. at 433). Thus, the dissolution of a limited liability company under LLCL 702 is initially a contract-based analysis. [Emphasis added.]
The absence of New York precedent leads Justice Austin to look to LLC caselaw in other states with the same statutory standard for dissolution. Prominent among these cases is the Delaware Chancery Court’s decision last year in Matter of Arrow Investment Advisors, LLC, 2009 WL 1101682 (Del Ch Apr. 23, 2009), where the court dismissed a minority member’s application for dissolution of an investment advisory firm that had ceased its advisory business and essentially was reduced to a holding company for the firm’s remaining cash and securities assets. The Chancery Court looked to the LLC agreement’s broad purpose clause (“such . . . lawful business as the Management Committee chooses to pursue”) in holding that, as quoted in 1545 Ocean,
“The court will not dissolve an LLC merely because the LLC has not experienced a smooth glide to profitability or because events have not turned out exactly as the LLC’s owners originally envisioned; such events are, of course, common in the risk-laden process of birthing new entities in the hope that they will become mature, profitable ventures. In part because a hair-trigger dissolution standard would ignore this market reality and thwart the expectations of reasonable investors that entities will not be judicially terminated simply because of some market turbulence, dissolution is reserved for situations in which the LLC’s management has become so dysfunctional or its business purpose so thwarted that it is no longer practicable to operate the business, such as in the case of a voting deadlock or where the defined purpose of the entity has become impossible to fulfill. . . . Dissolution of an entity chartered for a broad business purpose remains possible upon a strong showing that a confluence of situationally specific adverse financial, market, product, managerial, or corporate governance circumstances make it nihilistic for the entity to continue.”
Other out-of-state cases cited by Justice Austin include Dunbar Group, LLC v Tignor, 267 Va 361, 593 SE2d 216 (2004), where the Supreme Court of Virginia, calling the statutory standard for dissolution a “strict one,” reversed an order of dissolution based on deadlock between two 50-50 members of an LLC after the lower court had expelled one of the two members from participating in management; Kirksey v Grohmann, 2008 SD 76, 754 NW2d 825 (2008), where the South Dakota Supreme Court found the standard satisfied in a deadlock situation that left two of four sisters without any meaningful say in the LLC’s business affairs contrary to the operating agreement; and a partnership case, Taki v Hami, 2001 WL 672399 (Mich. App. 2001), in which a Michigan appellate court granted dissolution where the two partners had not spoken in years and there were allegations of violence and expulsion.
Drawing on these cases, as well as the language of §702, Justice Austin announced the court’s interpretation of the standard for LLC dissolution as follows:
After careful examination of the various factors considered in applying the “not reasonably practicable” standard, we hold that for dissolution of a limited liability company pursuant to LLCL 702, the petitioning member must establish, in the context of the terms of the operating agreement or articles of incorporation, that (1) the management of the entity is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved, or (2) continuing the entity is financially unfeasible.
Notice how the two prongs of the standard — I’ll call them failed purpose and financial failure –are stated in the disjunctive but that each must be analyzed through the prism of the operating agreement or, if there is no operating agreement, in light of the LLC Law’s default provisions. This is a significant shift from the less refined and arguably more liberal standard articulated in the one trial court decision that had gained a following, Schindler v. Niche Media Holdings, 1 Misc 3d 713 (Sup Ct NY County 2003), where the court wrote that dissolution of an LLC under §702 is available only if the company “is unable to function as intended, or else that is it failing financially.” Henceforth, financial failure alone will not be enough to justify the drastic remedy of dissolution unless such failure is accompanied by, or results from, a frustration of the LLC’s purpose that cannot be addressed or remediated by the operating agreement or articles of organization.
Notice also that, in contrast with the formulation recently used by the Delaware Chancery Court in the Lola Cars v. Krohn Racing case (read my post on Lola here), the 1545 Ocean court’s formulation does not specify manager deadlock as a basis for dissolution. Indeed, Justice Austin elsewhere in his opinion states that deadlock, while expressly made a basis for dissolution of close corporations under BCL §1104, is not an “independent ground for dissolution” under §702. The court instead “must consider the managers’ disagreement in light of the operating agreement and the continued ability of [the LLC] to function in that context.” Presumably such consideration of deadlock fits within the unable-to-achieve-LLC’s-purpose aspect of the failed-purpose prong, whereas the unwilling-to aspect seems better suited to dissolution cases brought by petitioners holding a minority membership interest.
- The Court’s Application of the Standard
Crown Royal argued for dissolution based on the parties’ failure to hold regular meetings, failure to achieve quorums, and deadlock over the construction work and, in particular, Van Houten’s continuation of the work using VHC despite King’s objections. Writing for the 3-judge majority, Justice Austin held that Crown Royal’s allegations “failed to meet the standard for dissolution enunciated here” and that, additionally, “there are numerous factors which support the conclusion that dissolution of 1545 LLC is inappropriate under the circumstances of this case.”
Why did Crown Royal’s petition fall short of the standard? First and foremost, Article 4.1 of the operating agreement (quoted above in the Facts section) permits one manager to act unilaterally unless the other manager’s approval is expressly required. As Justice Austin noted, “[t]his provision does not require that the managers conduct the business of 1545 LLC by majority vote.” Rather, he continued,
[i]t empowers each manager to act autonomously and to unilaterally bind the entity in furtherance of the business of the entity. The 1545 LLC operating agreement, however, is silent as to the issue of manager conflicts. Thus, the only basis for dissolution can be if 1545 LLC cannot effectively operate under the operating agreement to meet and achieve the purpose for which it was created. In this case, that is the development of the property which purpose, despite the disagreements between the managing members, was being met.
The operating agreement likewise did not require regular meetings or quorums. Instead, it merely provided for meetings to be held at such times as the managers “may from time to time determine.” The record before the court, Justice Austin found, “demonstrates that the managers, King and Van Houten, communicated with each other on a regular basis without the formality of a noticed meeting which appears to conform with the spirit and letter of the operating agreement and the continued ability of 1545 LLC to function in that context.”
What other circumstances rendered dissolution inappropriate? Justice Austin identifies three. First, the dispute between King and Van Houten “was not shown to be inimicable to achieving the purpose of 1545 LLC.” King “never objected to the quality of Van Houten’s construction work, but only to its expense”. King “approved and praised” the work which was all but complete as to Building A.
Second, LLC Law §411 permits an LLC to avoid contracts entered into between it and an interested manager or another company in which a manager has an interest, unless the manager can prove the contract was fair and reasonable. Crown Royal could have, but did not, take action against the contract with VHC under §411. On the contrary, Justice Austin stressed, Crown Royal “ratified, albeit grudgingly at times, Van Houten’s unilateral efforts.” In any event, he continued, “a fair reading of LLCL 702 demonstrates that an application to dissolve 1545 LLC does not flow from a claim under LLCL 411.”
Third, if aggrieved by Van Houten’s actions as manager Crown Royal has an alternative remedy in the form of a common law derivative action under Tzolis v. Wolff, 10 NY3d 100 (2008). Such remedy, however, “cannot serve as the basis for dissolution unless the wrongful acts of a managing member which give rise to the derivative claim are contrary to the contemplated functioning and purpose of the limited liability company.”
Justice Fisher’s Partial Dissent
Justice Fisher’s partial dissent begins with the observation that he has “no serious quarrel” with the standard for dissolution adopted by the majority. He briefly recounts the “growing disputes” between King and Van Houten over the latter’s alleged mismanagement and billing improprieties in connection with the construction project. Justice Fisher states that Van Houten disputed many of King’s allegations, and he notes that the lower court “made no findings of fact.” Without such factual findings, he continues,
we cannot meaningfully decide whether the Supreme Court providently exercised its discretion in finding that the actions of the parties rendered it not reasonably practicable for 1545 LLC to carry on its business in conformity with its articles of organization or operating agreement. Accordingly, I would remit the matter to the Supreme Court, Suffolk County, for a fact-finding hearing and thereafter for a new determination on the petition (cf. Business Corporation Law § 1109; Sobol v Les Pieds Nickels, 262 AD2d 194, 196; Matter of Giordano v Stark, 229 AD2d 493, 494-495).
The requirement or not of a hearing in judicial dissolution proceedings can be as important to the outcome of the dispute as the formulation of the dissolution standard. I’ve seen dozens of appellate decisions reversing the grant or denial of a dissolution petition due to the lower court’s failure to conduct an evidentiary hearing in the presence of conflicting affidavits concerning material issues of fact. I doubt that the majority’s summary dismissal of Crown Royal’s petition is intended to signal a change in direction on that score. Rather, the majority’s disposition likely reflects its belief, not shared by the dissenters, that even crediting all of Crown Royal’s factual allegations, along with its admissions as to the quality of VHC’s work, it still does not meet the threshold for judicial dissolution of 1545 LLC.
Under §5601(a) of the Civil Practice Law and Rules, the dissent by two justices of the Appellate Division may permit Crown Royal to appeal as of right to New York’s highest court, known as the Court of Appeals, at least with respect to the issue of its entitlement to a hearing. We’ll just have to wait and see whether Crown Royal exercises its appellate rights or, perhaps, reaches some buy-out agreement or other accommodation with its business partner.
Addendum: Read here Professor Larry Ribstein’s commentary on the Ocean 1545 case, from which I here quote his concluding paragraph emphasizing the importance of careful drafting of the LLC agreement:
In short, it seems that NY is joining Delaware in emphasizing the role of the operating agreement in judicial dissolution cases. As noted above, this could emerge as an important distinction between LLCs and close corporations, and therefore a factor in choice of form. It also places new emphasis on the need for care in drafting the operating agreement. However, New York has not yet explicitly embraced the operating agreement as determinative. We will have to await further developments to see if New York can shed its long legacy of close corporation law in LLC dissolution cases.