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NY Business Divorce Information on Dissolution and Other Disputes Among Owners of New York Corporations, LLCs and Partnerships

Can a Member of a Member of an LLC Sue to Dissolve the LLC?

Posted in Derivative Actions, LLCs, Standing

A lawsuit between the owners of an upper east side Manhattan “gentlemen’s club” called Sapphire, involving charges of self-dealing and financial abuse by the managing partner, led to an interesting but not surprising decision earlier this month, holding that a member of LLC #1 which, in turn, is a member of LLC #2, lacks standing to seek judicial dissolution of LLC #2. JG Club Holdings, LLC v. Jacaranda Holdings, LLC, 2012 NY Slip Op 50724(U) (Sup Ct NY County Apr. 20, 2012).

The club, owned and operated by a New York limited liability company called Jacaranda Club, LLC (“Sapphire”), arose from the ashes of the notorious Scores strip club that closed down at the same location in 2008. According to its December 2008 Operating Agreement (read here), Sapphire started operations with two members: Jacaranda Holdings, LLC (“Jacaranda”) as the 51.1% managing member and TDK Holdings, LLC (“TDK”) as the 48.9% non-managing member. TDK with Jacaranda’s consent subsequently assigned its entire membership interest to JG Club Holdings, LLC (“JG”) whose membership included Jeffrey Wasserman (the “JG Controlling Member”) as the managing majority member, and two non-managing minority members, GRKS II LLC and DZ Ventures LLC (collectively, the “JG Minority Members”).

In December 2010, the JG Controlling Member brought suit in JG’s name (read complaint here) against Jacaranda, its principal, Michael Talla, and a separate company controlled by Talla called Club at 60th St., Inc. (“60th St.”) from which Sapphire leased its club facility, asserting a number of individual and derivative claims on Sapphire’s behalf. The suit’s gravamen is that Talla/60th St. charged Sapphire grossly excessive rents and also used Sapphire’s funds to pay the defendants’ separate loan obligations. The complaint did not seek judicial dissolution of Sapphire.

Following a series of inconclusive skirmishes over discovery disputes, in November 2011 the JG Minority Members by their own counsel filed a motion for leave to intervene as plaintiffs. Their proposed intervention complaint (read here) alleged that the relief sought in JG’s complaint was inadequate or inappropriate, and requested that the court instead dissolve Sapphire pursuant to §702 of the LLC Law. Their memorandum of law in support of intervention (read here) argued that, as members of JG, they were entitled to seek dissolution of Sapphire derivatively on behalf of JG under the authority of Tzolis v. Wolff, 10 NY3d 100 (2008), in which the New York Court of Appeals recognized a common law right of an LLC member to sue derivatively.

The defendants’ opposing brief (read here) argued that LLC Law §702 by its plain wording limits standing to seek dissolution to a “member.” Defendants also argued, even assuming there is derivative standing to seek dissolution, that the JG Minority Members did not plead and could not satisfy the demand or demand futility prerequisite for a derivative action, especially since the JG Controlling Member had already brought an action in the name of JG alleging financial misconduct by the defendants. The fact that the JG Controlling Member chose not to seek a dissolution remedy reflects a business judgment that the court should respect, they further argued.

The JG Minority Members replied with their own affidavits (read one of them here) and — how odd is this? – the affidavit of the JG Controlling Member (read here) stating that the three of them had discussed and agreed that Sapphire should be dissolved and that, although the JG Controlling Member did not intend to apply for dissolution of Sapphire on behalf of JG, he ”invited” the JG Minority Members to seek dissolution of Sapphire if they considered it “appropriate.”

The intervention application was heard by New York County Commercial Division Justice Shirley Werner Kornreich who, at a conference on January 31, 2012, requested that counsel submit supplemental authority for their position on derivative standing to seek dissolution. The intervenors’ counsel submitted a letter restating their reliance on Tzolis v. Wolff (read here). The defendants’ counsel submitted a letter citing a Delaware Chancery Court decision, R&R Capital, LLC v. Buck & Doe Run Valley Farms, LLC, 2008 WL 3846318 (Del. Ch. Aug. 19, 2008), in which the court rejected on standing grounds a request for dissolution by a member of a member of the subject Delaware LLC. (Read here the letter and here my post on R&R Capital).

Justice Kornreich’s decision denies the intervention application for lack of standing to seek dissolution under the statute, stating:

Section 702 of the LLCL provides that a court may grant dissolution upon “application by or for a member….” The parties have pointed to no precedent, and the court’s independent research has discovered none, extending the right to seek dissolution of a limited liability company to non-members. All of the New York precedents confer or deny standing based upon membership. See, e.g., Matter of Cline v Donovan, 72 AD3d 471, 472-472 (1st Dept 2010) (dissolution should not have been granted due to question of fact as to whether petitioner was member of LLC); Caplash v Rochester Oral & Maxillofacial Surgery Assoc., LLC, 63 AD3d 1683 (4th Dept 2009) (plaintiff had standing to dissolve LLC because his resignation as member was not effective before he moved for dissolution).

As the quoted passage notes, neither of the two cited cases dealt with the issue of derivative standing to seek dissolution, so it appears that Justice Kornreich is the first to pronounce on the issue, at least in New York.

Justice Kornreich apparently let the parties know which way the wind was blowing at the late January conference, because shortly thereafter, counsel for JG filed an amended complaint tacking on a claim for judicial dissolution of Sapphire (read here), thereby effectively mooting the issue of the JG Minority Members’ standing to dissolve Sapphire.

The membership limitation on standing to seek LLC dissolution is more important than you might think. Unlike subchapter S close corporations that generally cannot have other limited liability entities as shareholders, LLCs often include in their membership ranks multi-shareholder corporations and/or multi-member LLCs which may in turn be composed of other multi-member LLCs. There may be circumstances of overlapping ownership and control, and divergent interests, that leave some stakeholders with no ability to seek judicial dissolution in their own right or through the entity in which they hold a direct interest. Like everything else in the world of LLCs, these are issues to be thought out and addressed in the operating agreement.

Finally, neither in the court’s decision nor the parties’ submissions in the Sapphire case is any special attention paid to §702′s use of the words “or for” in the section’s standing formulation, “[o]n application by or for a member . . ..” The formulation is lifted verbatim from §121-802 of New York’s Revised Limited Partnership Act authorizing judicial dissolution “[o]n application by or for a partner” and is also commonly found in many other states’ limited partnership and LLC dissolution statutes. Might “for a member” support derivative standing to seek dissolution? Please leave a comment if you’ve seen this issue addressed anywhere.

Response from Professor Daniel S. Kleinberger

I’m pleased to be able to share the following response to my query received from Professor Daniel Kleinberger of the William Mitchell College of Law, one of the foremost experts on the law of business organizations. Professor Kleinberger has been immersed in legislative drafting projects for more than two decades, and his scholarship and drafting work have been recognized by the National Conference of Commissioners on Uniform State Laws, the American Law Institute, the American Bar Association Committee on Limited Liability Companies, Partnerships and Unincorporated Entities, and the Section on Agency, Partnership, LLCs and Unincorporated Associations of the American Association of Law Schools.

Peter,

I’ve done some looking into the question of whether “by or for a member” would support derivative standing to seek dissolution. For several reasons, I believe the answer should be no.

First, the origins of the phrase argue against the notion that “for” can encompass derivative claims. The phrase derives from the original Uniform Partnership Act, § 32(1) (“On application by or for a partner the court shall decree a dissolution whenever ….”). Like much of the UPA, § 32 derives from the comparable provision of the English Partnership Act of 1890, which notably does not include the phrase “or for”. Partnership Act of 1890, § 35 (“On application by a partner the Court may decree a dissolution of the partnership in any of the following cases: …..).

The Official Comments to UPA § 32 do not explain the added language, but it is highly unlikely that the drafters had derivative litigation in mind. Then and now, the derivative suit does not exist with regard to general partnerships. See RUPA § 405; Daniel S. Kleinberger, “The Closely Held Business through the Entity-Aggregate Prism,” 40 WAKE FOREST L. REV. 827, 842 (2005) (“RUPA purposefully eschews one of the most logical consequences of entity status–namely, a distinction (with consequences) between direct and derivative claims. ‘RUPA does not authorize derivative actions,’ and each partner has standing to bring claims directly for injuries suffered by the partnership.) (footnotes omitted; quoting RUPA § 405, cmt. 2).

To state that a paucity of case law exists would overstate the number of cases. The longest discussion I have found comprises two paragraphs in an almost 60-year-old New Jersey decision:

The plaintiff applied for dissolution of a partnership formed by the defendant Nicholas Lo Conte and his brother, plaintiff’s husband, Michael Lo Conte, now absent, and for the appointment of a receiver of the property and assets of the partnership. The defendants resist on the ground that the plaintiff is not a proper party to make the application, because R.S. 42:1-32, N.J.S.A. [UPA § 32], provides that the court shall under certain circumstances decree a dissolution ‘On application by or for a partner’ and that the plaintiff being neither a partner, the personal representative or agent of a partner cannot make application ‘by or for a partner.’

Had it been the intent of the Legislature to limit the persons, other than partners, who may make application to the court strictly to personal representatives or agents of partners, it would have done so. The statute does not in any wise specify who may make application ‘for a partner.’ In the absence of any limitation, it is to be presumed that any party in interest may make such application-certainly equity dictates that it may properly be made by a person as much in interest as the wife of an absent partner.

Lo Conte for the Use and Benefit of Lo Conte v. Lo Conte, 25 N.J.Super. 42, 43-44, 95 A.2d 443, 443 – 444 (N.J.Super.Ch. 1953). Perhaps to the contrary, at least implicitly, is Jacoby v. Feldman, 81 Cal.App.3d 432, 442, 146 Cal.Rptr. 334, 339 – 340 (Cal.App. 1978) (ignoring the “or for” language, while “hav[ing] no difficulty in holding that [a deceased partner’s estate] was a partner within the meaning of Corporations Code section 15032 [(UPA § 32]”).

In any event, given that derivative suits are inapposite to general partnerships (the source of the “or for” language), I doubt even that a court that found and followed Lo Conte would consider a member X of LLC #1 to be as closely connected to LLC #2 (of which LLC #1 is a member but X is not), as is “the wife of an absent partner” to the absent partner.

As to whether X should be have the right to bring a double derivative suit for dissolution of LLC #2, in JG Club Holdings, LLC v. Jacaranda Holdings, LLC Judge Kornreich held pithily to the contrary. “The parties have pointed to no precedent, and the court’s independent research has discovered none, extending the right to seek dissolution of a limited liability company to non-members…. Furthermore, after this motion [for intervention in the nature of a double derivative suit] was submitted, JG [LLC #1] filed a second amended complaint asserting a claim for dissolution of the Club [LLC #2]. If the Proposed Intervenors feel that JG is being managed improperly, they can bring a derivative action against its management.” JG Club Holdings, LLC v. Jacaranda Holdings, LLC, 2012 NY Slip Op 50724(U) (Supr. Ct. NY Co. April 20, 2012) at 3.

Those familiar with the complexity and rationale for double derivative suits will likely agree with Judge Kornreich. For an excellent introduction to the complexity, see Lambrecht v. O’Neal, 3 A.3d 277, 281-287 (Del. 2010). The short version is simply this:

  1. In the pure, conceptual sense, in a double derivative suit:
  • The plaintiff is a person who is a co-owner (e.g., stockholder, limited partner, member) of Entity #1 but not of Entity #2.
  • Entity #1 is a co-owner of Entity #2 and, in the judgment of the plaintiff:
    • those who manage Entity #2 have wrongfully damaged Entity #2;
    • not surprisingly, those who manage Entity #2 are not pursuing the miscreants (i.e., themselves); and
    • Entity#1 could bring a derivative action in the name and to the benefit of Entity #2, but the managers of Entity #1 are not properly asserting Entity #1’s rights to bring derivative claims on behalf of Entity #2.
  • The plaintiff (as a co-owner of Entity #1 but not of Entity #2) seeks to “take control” of Entity #1 for the purpose of invoking Entity #1’s right to sue derivatively on behalf of Entity #2 and against the managerial miscreants who have allegedly harmed Entity #2 (and indirectly Entity #1 and even more indirectly the plaintiff).
  • The law of derivative actions has both a contemporaneous and continuous ownership requirement. Subject to exceptions not relevant here, the derivative plaintiff must have been a co-owner of the directly damaged entity as of the time of the misconduct and must remain a co-owner of that entity throughout the derivative lawsuit.
  1. Any double derivative lawsuit flunks one or both of those requirements.
  2. Courts (particularly Delaware courts) have made exceptions to those requirements only when a merger or comparable transaction has made a direct derivative suit impossible.

Such impossibility does not exist when LLC #1 exists and is a member of LLC #2. If LLC #1 is “messing up” as it asserts (or fails to assert) its rights viz a viz those who manage LLC #2, the members of LLC #1 have a derivative claim – on behalf of LLC #1 against the managers of LLC #1. To reiterate Judge Kornreich’s words: “If [the members of LLC #1] feel that [LLC #1] is being managed improperly, they can bring a derivative action against its management.” JG Club Holdings, LLC v. Jacaranda Holdings, LLC, 2012 NY Slip Op 50724(U) (Supr. Ct. NY Co. April 20, 2012) at 3.

If the mismanagement concerns LLC #1’s failure to sue derivatively in the name of LLC #2, in theory the court in the initial derivative action could order the managers of LLC #1 to remedy that failure and cause LLC #1 to sue derivatively on behalf of LLC #2.

Attorneys who think such an order is likely resemble the White Queen in Alice in Wonderland – i.e., they are capable of “believ[ing] in ‘as many as six impossible things before breakfast.’” In re Trejos, 352 B.R. 249, 254 (Bkrtcy.D.Nev. 2006) (quoting Lewis Carroll, Alice’s Adventures in Wonderland & Through the Looking Glass, ch.5, at 157 (Bantam Classic ed.1981) (1865 & 1871)).