This article was co-authored by Franklin C. McRoberts, counsel in the Uniondale office of Farrell Fritz and a member of the firm’s Business Divorce Group.
The rules of “standing” in business divorce litigation generally require that the plaintiff have an ownership interest in the business entity at the time of the alleged wrongful conduct and, for derivative claims brought on the entity’s behalf, throughout the litigation.
In Lewis v Alcobi, 2017 NY Slip Op 30664(U) [Sup Ct NY County Apr. 6, 2017], Manhattan Commercial Division Justice Anil C. Singh considered whether a parent’s assignment of her young daughter’s membership interest in a limited liability company as security for the other parent’s unpaid debt deprived the daughter of standing to sue, despite the daughter’s claim to have received no consideration for the assignment.
The case provides useful lessons for litigating disputes of this sort and, perhaps more importantly, for transactional attorneys considering the use of LLC membership interests to secure payment obligations.
In 2007, three individuals as co-equal members formed an LLC to own and manage a commercial property in Yonkers, New York. Their operating agreement permitted transfers of membership interests to immediate family members. A year later, with the other members’ consent, one of them assigned his full membership interest to his infant daughter.
Subsequently, the father and one of the original two members — let’s call him Member A — resolved a dispute with a written settlement agreement whereby the father agreed to pay Member A $190,000 in two installments of $95,000 each due over a 17-month period.
The day after the father signed the settlement agreement, his wife, as guardian of their minor daughter, executed a two-page agreement transferring outright the daughter’s one-third membership interest in the LLC to Member A, subject to a right to repurchase the interest for $10 once the father paid his $190,000 debt to Member A.
In what later became a crucial factor in the court’s decision, the transfer agreement recited that the mother (as guardian) “has this day, upon execution of this Agreement and for valuable consideration receipt of which to [sic] hereby acknowledged, by all parties, caused the [daughter’s] interest to be transferred to [Member A].”
Notwithstanding the outright transfer, the agreement also provided the daughter would continue to receive, during the father’s debt repayment period,
the right to the cash flow of the [daughter’s] Interest, but only 33 1/3% such cash flow as may arise from the ordinary course of business and obligations of the Company. All other economic benefits of the Interest in the Company transferred herein to [Member A] shall be retained by [Member A] during his period of ownership.
Several years later, and even though the father did not satisfy his $190,000 debt to Member A, the daughter by her father as guardian brought suit against Member A and the other original member, asserting individual and derivative claims for breach of operating agreement, breach of fiduciary duty, etc., contending that the defendants distributed profits only to themselves and were operating the company “for their sole benefit.”
The daughter later sought to amend her complaint to allege an additional claim that the assignment of her membership interest was “void” because she “did not receive any consideration in exchange for the transfer of her ownership interest in the LLC to [Member A].”
In the first of two decisions, Justice Singh denied the motion, holding that the transfer agreement “expressly stated that the transfer was for valuable consideration” and that the plaintiff “did not submit any evidence to contradict the statement.” That ruling was affirmed on appeal.
The Court’s Decision Dismissing the Action
The defendants eventually moved for summary judgment dismissing the complaint. They argued that the daughter lacked standing to sue individually or derivatively because she had no membership interest in the LLC as the result of her transfer to Member A. Defendants noted that because the father never repaid the $190,000 he owed Member A under their settlement agreement, the daughter lost her right to repurchase her membership interest.
The daughter cross-moved for an order that the transfer was void for lack of consideration, arguing that the court’s prior denial of her motion to amend the complaint to assert a claim for unenforceability of the transfer agreement was not an adjudication on the merits. In support, she and her mother submitted unsworn, unsigned statements — which the court in its decision labeled “inadmissible” and expressly declined to consider — alleging that the daughter assigned her membership interest at the “behest” of her father and that she did not receive consideration for the assignment.
The father submitted his own affidavit stating that he asked his wife to transfer their daughter’s interest in the LLC to protect himself from a lawsuit by Member A and that his daughter “did not receive consideration for the transfer.”
In his recent decision, Justice Singh held that the daughter’s evidentiary submissions failed to raise a triable issue of fact, and he granted defendants’ motion for summary judgment dismissing the complaint for lack of standing:
Defendants have shown that on February 10, 2009, via the Transfer Agreement, [the daughter’s] one third ownership interest in the LLC was transferred to [Member A] and, therefore, she no longer has an interest in the LLC. Moreover, defendants have shown that, although the Transfer Agreement provides that her interest could be repurchased for $10, if [the father] made two timely payments of $95,000, [the father] did not make those payments.
Justice Singh also held that his prior ruling, affirmed on appeal, denying the daughter’s motion to amend the complaint to allege lack of enforceability of the transfer agreement, was a decision “on the merits,” and therefore, was binding as the “law of the case.”
Based on his finding that the daughter received valid consideration for the assignment of her LLC interest, Justice Singh concluded:
[The daughter’s] claims, accruing in 2010, that defendants breached the LLC’s operating agreement, breached their fiduciary duty, breached their duty of good faith and fair dealing, and were unjustly enriched to her detriment, must be dismissed because she had no interest in the LLC in 2010. Further, she has no standing to bring a derivative action, on behalf of the LLC, for any alleged misdeed in 2010. Likewise, her claims for injunctive relief due to defendants’ alleged misdeeds, must also be dismissed. In sum, the complaint must be dismissed in its entirety.
The daughter did not walk away completely empty handed. The defendants conceded that, under the transfer agreement, she was entitled to approximately $3,000 plus interest representing her one-third share of the LLC’s cash flow during the repayment period of her father’s debt to Member A.
There are lessons for both litigators and transactional attorneys in this case.
For litigators, the most obvious lesson is not to rely on unsworn, much less unsigned, witness statements in opposition to a summary judgment motion. Such “evidence” has no probative value and will be ignored by the court.
Another takeaway for litigators concerns the filing of the lawsuit in the name of the father as guardian for his daughter. The father, after all, was the apparent sole beneficiary of the transfer of his daughter’s membership interest as security for the father’s settlement agreement with Member A, which the father apparently breached by failing to pay the $190,000. Certainly it gives the appearance of the father wanting to eat his cake and have it too. If nothing else, the optics would have been better if the mother had filed suit as the daughter’s guardian, assuming her willingness and ability to do so.
For transactional attorneys, the case presents a highly unorthodox form of debt securitization with greatly elevated risk for the daughter notwithstanding her contingent right to repurchase her membership interest upon the father’s satisfaction of the debt. The transfer agreement signed by the wife imposed no restrictions on the voting and management rights appurtenant to the transferred interest other than transactions out of the ordinary course of the LLC’s business. It’s not even clear that the LLC’s sole realty asset couldn’t have been sold during the repayment period in light of the LLC operating agreement’s purpose clause which expressly contemplates conveyance of the realty.
Instead one would expect to see the daughter’s certificated LLC interest placed in escrow and pledged as collateral security for the father’s repayment to Member A rather than an outright transfer. A pledge of collateral security also would protect the pledgor’s equity interest to the extent its value exceeds the debt obligation.
One also would expect, for Member A’s protection, the simultaneous making of the father’s settlement agreement and the daughter’s assignment instead of the latter a day after the former, and a more detailed and substantive recitation of the consideration received by the daughter, better evidencing the benefit flowing to her from Member A’s forbearance from bringing suit against her father.