If there’s a common theme to the trio of LLC cases highlighted in this post, it’s that having a well-crafted written operating agreement is no guarantee there won’t be a litigation dust-up, while not having a written operating agreement greatly enhances the odds of a legal dispute among members at some point down the road.
Let’s start with the well-crafted operating agreement in Estate of Calderwood v Ace Group International LLC, 2016 NY Slip Op 30591(U) [Sup Ct NY County Feb. 29, 2016], in which Manhattan Commercial Division Justice Shirley Werner Kornreich ruled that upon the death of the subject Delaware LLC’s majority member, under the express terms of Sections 9.7 and 7.1 of the LLC Agreement (read here), his estate was deemed a “Withdrawing Member” with no management rights and retaining solely the right to receive distributions.
The estate argued that the cited sections either did not apply to the deceased founding member or were ambiguous, and that the governing Delaware LLC Act mandates recognition of the estate’s undiminished member rights. Justice Kornreich’s legal analysis rejecting these arguments, and finding that the cited provisions unambiguously stripped the estate of all member rights save distributions, includes a detailed discussion of Delaware’s rules of contract construction when confronted with competing interpretations, which, she points out in a footnote, “grant courts more power [than under New York’s rules of construction] to rule on a contract’s meaning as a matter of law if there is a superior interpretation.”
The estate fared no better with its alternative reliance on Delaware LLC Act § 18-705 (the analog to New York LLC Law § 608), providing that the personal representative of a deceased member “may exercise all of the member’s rights for the purpose of settling the member’s estate or administering the member’s property, including the power under a [LLC] agreement of an assignee to become a company member.” The estate argued that the statute was mandatory, and not permissive, because it lacks the magical “unless otherwise provided in the LLC agreement” language. Noting that the statute “does not purport to define” the referenced “member’s rights,” Justice Kornreich wrote:
To hold that § 18-705 alters a member’s rights upon death in a manner contravening the LLC Agreement is inconsistent with the well settled law articulated by the Delaware courts — that the substantive rights of the LLC members are governed by contract. § 18-705 permits the Estate to control the bundle of rights associated with [the deceased member’s] interest in the Company existing after his death in a manner consistent with the Agreement. The scope of those rights is defined in the Agreement.
Now we come to the cases with no operating agreements, both involving New York LLCs. In Mickenberg v 218 Thompson Street, LLC, Short Form Order, Index No. 601842/15 [Sup Ct Suffolk County Apr. 12, 2016], the plaintiff 25% LLC member sought a declaratory judgment that he is entitled to appraisal rights and a buy-out by the other members and, failing that, dissolution of the LLC whose sole asset is a mixed use building in New York City’s Greenwich Village allegedly worth at least $12 million.
The LLC’s articles of organization were typically bare-boned. The complaint alleged both that the LLC’s purpose is “to own and operate the Property in such manner so as to provide for the financial needs of the members as they may require” and that “the four members have never been able to agree on the purpose of the Company and how the Company should be operated.” Essentially, plaintiff contended that the defendants unjustifiably refused his request to allow him to obtain a $1 million loan secured by plaintiff’s interest in the LLC and its realty to meet his financial needs occasioned by his impending retirement and his wife’s medical expenses.
The defendants (all relatives of plaintiff) moved to dismiss the complaint, arguing that the LLC was debt-free and highly profitable; that New York law does not recognize an LLC member’s cause of action for appraisal rights; and that notwithstanding the absence of an operating agreement, the LLC’s intended purpose to own and operate the realty was being achieved with great financial success.
After rejecting defendants’ procedural challenges based on improper venue and defective form of proceeding, Suffolk County Commercial Division Justice Elizabeth Hazlitt Emerson reserved decision on the defendants’ substantive branches pending submission of supplemental papers within 90 days during which she directed the parties to conduct limited discovery “on the single issue of the purpose for which 218 Thompson Street, LLC, was formed” including “depositions of any third parties who were involved in the creation of the LLC.”
The Mickenberg decision is reminiscent of the Natanel case in which the court conducted a trial to determine the intended purpose of a single-asset realty LLC which had no written operating agreement. Whether a trial likewise will be required in Mickenberg will have to await the outcome of the court’s ruling following limited discovery.
I’ve seen many LLC cases in which the parties form and start operating the business on a handshake with the intention of later preparing and entering into an operating agreement, and then getting into trouble early on — especially before the LLC files its initial tax returns identifying the members and their ownership percentages — when they have a falling out after failing to reach agreement on terms or other new circumstances arise causing a rift.
Genovese v Guzman, Decision and Order, Index No. 608246/15 [Sup Ct Nassau County Mar. 31, 2016], is another one of those cases. The plaintiff had an established construction company that employed the two defendants. The three of them allegedly agreed to form a new LLC as equal members, to which the plaintiff would transition his existing company’s business. The new LLC was formed in June 2015 and began operating even though the three of them were unable to come to terms on an acceptable operating agreement.
According to the defendants, the sole reason plaintiff was to be a member of the new LLC was to act as a surety for pre-construction agreements. In September 2015, after they obtained other financing and no longer needed plaintiff’s bonding capacity, the defendants “had a meeting as 2/3 members . . . and decided by a majority vote to eliminate [plaintiff] from [the LLC].” The defendants subsequently entered into an operating agreement naming themselves as sole members with a 50% interest each.
The plaintiff brought suit seeking a declaration that he is a member of the LLC and access to its books and records, and also demanding either dissolution or a compelled buy-out of his one-third membership interest. The plaintiff also moved for a preliminary injunction preventing defendants from taking any distributions or engaging in any activities outside the normal course of business.
The injunction motion spawned a decision by Nassau County Commercial Division Justice Vito M. DeStefano, in which he found that the plaintiff established a likelihood of success on the merits of his claim of membership in the LLC. The court’s decision rested on two key pieces of evidence. First, the statement in the opposing affidavit of one of the defendants, that he and the other defendant “had a meeting as 2/3 members” and “decided by a majority vote to eliminate” plaintiff from the LLC, “necessarily implies that [plaintiff] was the other 1/3 member” at the LLC’s inception. Second, the LLC’s articles of organization contained no provision authorizing expulsion of a member, thus at the time of plaintiff’s supposed expulsion, under the governing default rules of the LLC Law “there was no voting mechanism in place or provision regarding the removal of a member.”
Finally, Justice DeStefano’s grant of injunctive relief also found that the plaintiff made a sufficient showing of irreparable harm in the absence of injunctive relief, and a balancing of the equities in his favor. The decision also granted plaintiff access to the LLC’s books and records as permitted pursuant to LLC Law § 1102 (b).
Genovese is a reminder that New York’s LLC Law, unlike LLC statutes in a number of other states, has no default rule authorizing member expulsion. Nor does New York’s statute include a judicial expulsion remedy. LLC owners who wish to retain authority to expel a member therefore must include an expulsion provision in the operating agreement.