The rules surrounding the death of a partner or a shareholder are familiar to most practitioners. For general partnerships governed by New York’s Uniform Partnership Act, except as otherwise provided by agreement, a partner’s death automatically triggers dissolution and liquidation, unless the surviving partners continue the business in which event they are required to pay the estate the fair market value of the deceased partner’s interest. (The rules are different in states that have enacted the Revised Uniform Partnership Act.)
For close corporations, except as otherwise provided by agreement, the deceased stockholder’s shares may freely be transferred to his or her heirs as provided by will or intestacy laws, in which event the transferee (and, in the interim, the estate representative) possesses the full panoply of voting and other statutorily enshrined rights including the right to bring a shareholder’s derivative action and the right to petition for judicial dissolution.
What about limited liability companies? Are the rules that apply following the death of an LLC member more like those for partnerships or corporations?
The answer is, neither. LLCs have their own, distinct, statutory default rules applicable when a member dies. In addition, as illustrated by a recent decision discussed below, the disposition and rights associated with the membership interest of a deceased member are uniquely amenable to the preferences of the LLC members as expressed in the operating agreement.
Death Default Rules
In the late 1980’s and early 1990’s, a tidal wave of LLC enabling legislation swept the country. New York’s original LLC Law, like most if not all LLC legislation, included a partnership-style default rule under which the death of a member triggered dissolution and liquidation unless the surviving members voted to continue. In the late 1990’s, after the IRS adopted the check-the-box regulations assuring partnership tax treatment for LLCs, a second wave of amendatory LLC legislation swept the country, including New York, which, among other changes, flipped the default rule so that the death of a member does not trigger dissolution unless the survivors vote to dissolve. The amended default rule is codified in Section 701(b) of New York’s LLC Law.
So if the LLC continues, what other statutory provisions regulate a deceased member’s interest? One of them is LLC Law § 608 which grants the estate representative limited powers to “exercise all of the member’s rights for the purpose of settling his or her estate . . . including any power under the operating agreement of an assignee to become a member.”
Section 608’s reference to the right of an assignee under the operating agreement “to become a member” implicates another default rule, codified in LLC Law §§ 602 and 603, under which the assignee of an LLC membership interest — including one who inherits a deceased member’s interest — is not admitted to membership in the LLC unless the LLC’s other members consent. Section 603(3) provides that, absent such consent, the “only effect of an assignment of a membership interest is to entitle the assignee to receive, to the extent assigned, the distributions and allocations of profits and losses to which the assignor would be entitled.” In other words, someone who inherits a deceased member’s LLC interest has an economic interest but no management or voting rights unless the other members grant full membership status.
The status of a non-member holder of an economic interest is somewhat akin to a limited partnership interest, but with even fewer rights. For instance, LLC Law § 1002(c) authorizes “[a]ny member that is a party to a proposed merger or consolidation who is entitled to vote with respect to such proposed merger or consolidation” to dissent from the merger or consolidation and be bought out for fair value. Likewise, LLC Law § 702 authorizes a member to apply for judicial dissolution of the LLC. Neither statute confers standing on a non-member holder of an economic interest.
However, the beauty of the LLC form is the broad freedom members have to bargain for contractual rights and obligations, embodied in an operating agreement, that modify or run contrary to the statutory default rules. Hence, the fact that the statute doesn’t offer non-members the right to dissent from a merger, or to seek judicial dissolution, is not necessarily the last word.
The Budis Case
On the other hand, sometimes the provisions of the operating agreement reinforce the statutory default rules, as illustrated in a recent, unpublished decision by Queens County Commercial Division Justice Orin R. Kitzes in Budis v Skoutelas, Short Form Order, Index No. 702060/13 [Sup Ct, Queens County July 16, 2014], in which the court held that the estate of a deceased LLC member had no standing to assert derivative claims on the LLC’s behalf.
Budis involved a family-owned real estate holding company organized as an LLC owned equally by three siblings, each of whom was designated in the operating agreement as a manager. One of the siblings died in 2009. Under her will, her interest in the LLC was to be transferred to a trust of which one of her two siblings was named trustee. The deceased sibling’s husband, as executor of his late wife’s estate, was supposed to transfer the interest to the trust but did not do so in light of a lawsuit he filed against his in-laws for alleged financial wrongdoing in their management of the LLC’s business affairs.
The surviving siblings moved to dismiss the complaint, contending that all 15 of its causes of action were derivative claims seeking recovery for alleged injury to the LLC, and that the estate lacked standing to sue derivatively because it wasn’t a member of the LLC. Their argument cited a provision in the LLC’s operating agreement deeming the death of a member as an “Involuntary Withdrawal” and, consistent with the statutory default rules, providing that
upon the occurrence of an Involuntary Withdrawal, the successor of the Withdrawn Member shall thereupon become an Interest Holder, but shall not become a Member. The successor Interest Holder shall have all the rights of an Interest Holder (i.e. the right to receive the profits, losses and distributions that the Member would have received, at the time the Member would otherwise have been entitled to receive them had the member not withdrawn), but shall not be entitled by reason of the withdrawal to receive in liquidation of the Interest, the fair market value of the Member’s Interest as of the date the Member involuntarily withdrew from the Company.
In opposition, the estate’s executor argued that his complaint included both direct and derivative claims, and that he had standing to assert derivative claims under Tzolis v Wolff, 10 NY3d 100 , in which New York’s highest court recognized a common-law right of LLC members to bring derivative actions. (Unlike many other states, including Delaware, New York’s LLC Law has no provision authorizing derivative claims.)
The executor contended that Tzolis‘s conferral of standing to sue derivatively should apply equally to a non-member with an ownership interest, otherwise there would exist no means of redress for alleged wrongdoing by the LLC’s managers. The defendants countered with post-Tzolis case law, including Billings v Bridgepoint Partners, LLC, 21 Misc 3d 535 [Sup Ct, Erie County 2008], denying derivative standing to a withdrawn member. The defendants also argued that a non-member interest holder is no different than a corporate income beneficiary who, the courts have held, lacks standing to bring a shareholder derivative action.
Justice Kitzes agreed with the defendants that all of the claims asserted in the executor’s complaint sought relief for alleged injury to the LLC and thus could only be prosecuted as derivative claims for which the executor lacked standing. Justice Kitzes’ ruling underscored the importance of the operating agreement’s Involuntary Withdrawal provision, writing:
According to the clear terms of the Operating Agreement, plaintiff is an interest holder but not a member of [the LLC] and, therefore, is not vested with the requisite member status necessary to bring this action. “To have standing in a derivative suit regarding an LLC, a plaintiff must own portions of the LLC” as a member (Cohen PDC LLC v Cheslock-Bakker Opportunity Fund, LP, 2010 WL 4530242, 2010 NY Slip Op 33108(U) [Sup Ct, NY County 2010].
Justice Kitzes also responded to the executor’s contention that, absent the ability to bring derivative claims, the estate would be left without a remedy for the managers’ alleged misconduct, by suggesting the executor consider pursuing in Surrogate’s Court any claims for fiduciary breach against the surviving sibling who, in addition to serving as manager of the LLC, was named in the decedent’s will as trustee of the trust into which the decedent’s LLC interest was to be transferred.
Another noteworthy feature of Budis concerns the executor’s contention, also rejected by Justice Kitzes, that the executor succeeded to his late wife’s position as one of the LLC’s three managers under the operating agreement’s provision stating that the LLC shall be managed by the three siblings “or the survivors thereof.” Justice Kitzes agreed with the defendants that “survivors” as used in the provision refers to the surviving managers, not the deceased manager’s surviving family members.
Disputes often follow the death of the co-owner of any type of closely held business entity, not just LLCs. The best way to avoid such disputes, of course, is to include in the owners’ agreement buy-sell provisions or other means of ensuring that the decedent’s heirs are not unfairly deprived of the entity’s economic benefits while also ensuring the entity’s survival and viability. In Budis, it appears that such planning took place through a combination of the operating agreement and the member’s testamentary trust, which is not all that unusual in a family-owned business. Budis does, however, underscore the extra diligence required for LLC planning due to the primacy of the members’ operating agreement and the weakness, relative to other business forms, of the statutory protections for non-member assignees of LLC interests.
Disclosure: My Farrell Fritz colleagues Eric Penzer and Aaron Zerykier represented the defendants in Budis.