Tzolis No Solace for Proponent of LLC Member Expulsion
Two cases do not a trend make, but I can't shake the feeling that the Brooklyn-based Second Department appeals court has clamped down on the era of freewheeling judicial remedies in business breakup cases involving limited liability companies.
As I reported here, last January the Second Department issued a major ruling in the 1545 Ocean Avenue case articulating a new, tougher standard for LLC dissolution, in line with the Delaware approach, in which freedom of contract and fidelity to the operating agreement are paramount. Earlier this month, the Second Department issued another significant ruling in Chiu v. Chiu, 2010 NY Slip Op 01768 (2d Dept Mar. 2, 2010), holding that courts have no statutory authority to order expulsion of an LLC member for alleged misconduct, absent language in the operating agreement expressly providing for an expulsion remedy. In so ruling, the court turned its back on the appellant's argument that judicial expulsion should be recognized as a common law remedy under the reasoning of the Court of Appeals' 2008 decision in Tzolis v. Wolff, 10 NY3d 100, where it divined a common law basis for LLC derivative actions.
Chiu arises from a bitter family dispute between older brother Winston Chiu (WC) and younger brother Man Choi Chiu (MCC) featuring multiple lawsuits over a real estate holding limited liability company called 42-52 Northern Blvd., LLC formed in 1999. The property was purchased for approximately $5.5 million. The LLC had no written operating agreement. The LLC's 1999 and 2000 tax returns identified WC and MCC as holding 25% and 75% interests, respectively. Under a 1999 agreement, WC had certain rights to purchase the 75% interest held by his brother.
Continue Reading...The Perils of For-Cause Expulsion Provisions in LLC Agreements
A number of valuable lessons can be learned from a recent decision by Manhattan Commercial Division Justice Melvin L. Schweitzer (pictured) in Jain v. Rasteh, Decision and Order, Index No. 109920-09 (Sup Ct NY County Feb. 1, 2010), where the court summarily dismissed a complaint by a minority member of a limited liability company who was expelled from the LLC for breach of its operating agreement.
The last time I wrote on the subject (read here) I noted that, unlike some other states, New York's LLC Law has no express provision authorizing or prohibiting member expulsion, although LLCL Section 701(b) mentions member expulsion in the context of various events (death, retirement, bankruptcy, etc.) not requiring the LLC's dissolution. Jain involved an LLC formed under Delaware's LLC Act, which, unlike New York's law, expressly authorizes the LLC agreement to provide for the elimination or forfeiture of a member's interest for failure to comply with the LLC agreement, or under any other circumstances specified in the LLC agreement (see Delaware LLC Act Section 18-306 and Section 18-502(c)).
The subject of Jain is a New York based, two-member company formed in Delaware in 2008 to provide investment management and advisory services for a hedge fund. The defendant Majority Member contributed most of the firm's capital and held an 83% profit interest. The plaintiff Minority Member held the balance. Section 5 of the LLC agreement designated the two as co-managers, however it also gave the Majority Member the final say in case of disagreement on any issue with specified exceptions such as dissolution and admission of new members.
Section 12 of the LLC agreement, entitled "Withdrawal of a Managing Member," included a subsection (a)(ii) governing involuntary withdrawal by the Minority member, authorizing the Majority Member to "require" him to withdraw at any time for "Cause" as defined. The definition included conviction for felony or violation of securities laws, fraud, or "a material breach of this Agreement." Section 13 of the LLC agreement entitled the Minority Member to be paid specified percentages of the firm's net profit over the three years following any such involuntary withdrawal, depending on the number of years of service. For termination after less than two years -- which is what happened -- the Minority Member's share of net profit goes from 4.25% in the first year down to about 1.4% in the third year. Under Section 17 of the LLC agreement, following his termination for any reason the Minority Member is prohibited for six months from competing with the company or soliciting any of its clients or employees.
Continue Reading...It Only Took 16 Years: New York Appellate Court Defines Standard for Judicial Dissolution of Limited Liability Companies
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, 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.
Continue Reading...Interview with Delaware LLC Experts and Practice Manual Co-Authors John Cunningham and Vernon Proctor: Part II
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Last week's post presented an interview with John Cunningham who, along with co-author Vernon Proctor, recently published the pictured practice manual called Drafting Delaware LLC Agreements. John, whose practice focuses on entity formation, addressed some important issues involving Delaware LLCs from the perspective of the drafter of the LLC agreement. In this Part II of the interview, we get Vern's perspective on Delaware LLCs as a seasoned litigator. As John explained last week, "Vern is the guy who makes sure that the book’s analysis of Delaware law is correct. Vern has an amazing knowledge of Delaware statutory and common law."
It's no surprise that John teamed up with Vern as his Delaware law expert. Vern is a founding partner of Proctor Heyman LLP in Wilmington, Delaware, where he has a diverse corporate litigation and counseling practice relating to Delaware business entities, primarily in the Delaware Court of Chancery. Vernon has lectured widely on subjects of Delaware corporate and limited partnership law, and he has served on the editorial boards of leading Delaware law publications. For ten years, he was a member of the Corporation Law Council of the Delaware State Bar Association, a group of attorneys that considers and recommends proposed changes to the Delaware General Corporation Law. He is currently a member of the Alternate Entities Committee of the Delaware State Bar Association, which serves the same function with respect to Delaware statutes governing general partnerships, limited partnerships, and limited liability companies.
In the following interview, Vern answers questions that I suspect are on the minds of many Delaware and non-Delaware lawyers, particularly litigators, whose practices deal with the evolving LLC form.
Mahler: There's a vast body of Delaware case law that lawyers should be aware of in forming Delaware LLCs. If you had to mention just the three or four most important cases, which would they be?
Proctor: As we say in the book, the most important (and, until recently, the only) Delaware Supreme Court opinion construing the Delaware Limited Liability Company Act is Elf Atochem N.A. v. Jaffari, 727 A.2d 286 (Del. 1999). There, the Court provided a comprehensive overview of the structure of the statute, highlighting freedom-of-contract principles and the manner of ascertaining mandatory, default and permissive provisions of the Act. Last month, the Supreme Court decided Olson v. Halvorsen, 2009 WL 4846616 (Del. Dec. 15, 2009), in which it affirmed a Chancery Court holding that the statute of frauds applies to Delaware LLC agreements, notwithstanding the Act’s express allowance of oral and implied LLC agreements. One of the most significant recent trial court decisions in the LLC area is Bay Center Apartments Owner, LLC v. Emery Bay PKI, LLC, 2009 WL 1124451 (Del. Ch. Apr. 20, 2009), where the Court of Chancery examined the efficacy of certain contractual attempts to restrict or eliminate common law fiduciary duties and applied the USACafes doctrine (directors of corporate general partners may owe fiduciary duties to the limited partners of the limited partnership, not just to the corporate general partner and its owners) in the LLC context. Finally, in R&R Capital, LLC v. Buck & Doe Run Valley farms, LLC, CA # 3803-CC (Del. Ch. Aug. 19, 2008), the Court of Chancery held as a matter of first impression that an LLC member could contractually waive its statutory right to seek judicial dissolution of a Delaware LLC, despite the absence from the statute of the phrase “unless otherwise provided in the LLC agreement.” As always in Delaware, check the unreported decisions!
Continue Reading...Interview with Delaware LLC Experts and Practice Manual Co-Authors John Cunningham and Vernon Proctor: Part I
In almost all states, the limited liability company in recent years has become the business organization form of choice for closely held entities. By far the most popular LLC Act for use in forming sophisticated LLCs is the Delaware Act. There are presently something like 7 million U.S. LLCs of which approximately 600,000 are Delaware LLCs.
As a New York practitioner who handles all types of messy disputes between business co-owners, I know first hand the outsized claim of Delaware law on jurisdictional choice of entity as well as the powerful influence of Delaware decisional law even in disputes involving non-Delaware entities. I also know -- because it's written right into the Delaware LLC Act -- that freedom of contract is the cornerstone of Delaware LLC jurisprudence, and therefore nothing contributes more to the long-term health and welfare of a Delaware LLC -- or any LLC, for that matter -- than having a carefully planned, comprehensive, forward-looking, well-drafted operating agreement.
In 2009, Wolters Kluwer Law & Business published what quickly has become the preeminent formbook and practice manual on forming Delaware LLCs entitled Drafting Delaware LLC Agreements. The co-authors are John M. Cunningham and Vernon R. Proctor. I am very pleased to present this first of a two-part interview of the authors of this extremely well-written and user-friendly manual, which also includes a CD containing over two dozen sample Delaware operating agreements.
In this first part of the interview I talk with John Cunningham (pictured left), a member of the New Hampshire and Massachusetts bars whose practice focuses on forming LLCs for business start-ups and on restructuring existing businesses. Among his many achievements John was a principal drafter of the New Hampshire LLC Act. He is not only the co-author of Drafting Delaware LLC Agreements but also is the sole author of Drafting Limited Liability Company Operating Agreements, the leading U.S. general (i.e., non-state specific) LLC formbook and practice manual. I hope you find the interview, which begins after the jump, as interesting and useful as I did.
Continue Reading...Do Advancement and Indemnification Rights Include Defense Costs of Litigation Misconduct After Officer Leaves Company?
If there's a more litigious partnership falling-out than that of the closely-held mortgage company, Private Capital Group (PCG), I don't know about it. The case, entitled Ficus Investments, Inc. v. Private Capital Management, LLC, has racked up 87 motions since it was filed in Manhattan Supreme Court in March 2007, including several contempt applications. The court's docket lists over 2,300 separate documents filed, and the case isn't even close to being tried. There have been three interlocutory appeals decided thus far, with several others awaiting decision. Did I mention the parties have filed at least five other, related cases?
PCG was a New York-based Florida limited liability company formed to buy, manage and sell non-performing mortgages. Ficus Investments, Inc. (Ficus), the 80% member and sole manager of PCG, put up $300 million debt financing. Private Capital Management (PCM), the 20% member, operated PCG's mortgage business by PCM's two beneficial owners, Thomas Donovan and Lawrence Cline. The conflagration started a little over a year after operations began, in March 2007, when Ficus ousted Donovan and Cline and brought suit accusing them of misappropriating over $20 million.
The complex, high stakes litigation not surprisingly has generated millions in legal bills, which in turn has spawned a litigation within the litigation over the issue of the defendants' entitlement to advancement and indemnification of legal expenses under the provisions of PCG's operating agreement.
A year ago I wrote about a January 2009 appellate decision in Ficus in which the court held that the primary defendant, Thomas Donovan, as a former officer of PCG was entitled to seek advancement of his legal defense costs under the operating agreement. The primary issue there was whether the trial court's issuance of preliminary injunctions against Donovan defeated his advancement rights. Manhattan Commercial Division Justice Bernard Fried ruled (read here), and the Appellate Division affirmed (read here), that the ultimate determination of Donovan's indemnification rights had no impact on his interim advancement rights under the operating agreement's terms. The rulings resulted in reimbursement to Donovan of approximately $1.5 million in legal fees incurred through the end of 2007, which was upheld by yet another appellate court ruling in June 2009 (read here).
As it turned out, 2007 was just a warm-up for the next year, in which Donovan incurred another $3.8 million in legal defense costs for which he also sought advancement. Ficus opposed the bulk of the request, arguing that Donovan was not entitled to advancement for fees incurred opposing Ficus's applications for discovery and contempt sanctions concerning Donovan's alleged misconduct after he was terminated as an officer, during the course of litigation. Donovan's alleged misconduct included the "hacking" of former co-defendant Cline's e-mail account -- early in the case Cline and Ficus entered into settlement and cooperation agreements -- and failing to turn over company books and records in violation of court order.
The arguments raised in this second go-round, and the court's recent decision in favor of Ficus, raise novel legal issues with important ramifications for advancement and indemnification litigation in this and other cases.
Continue Reading...Two-Member LLC Operating Agreement Contains Recipe for Dissension and Litigation
Last month, in Lola Cars International, Ltd. v. Krohn Racing, LLC, No. 4479-VCN (Del. Ch. Nov. 12, 2009), Vice Chancellor John W. Noble of the Delaware Court of Chancery issued a 31-page letter opinion addressing a number of important issues, including the adequacy of a deadlock dissolution claim, in a dispute involving a two-member Delaware LLC that built and sold Daytona-class Lola race cars (pictured). The case is noteworthy in the business divorce arena for two reasons, one spot-lighted by the decision and the other further off-stage.
The plaintiff, Lola Cars International, Ltd. ("LCI"), as 51% member teamed with defendant Krohn Racing, LLC ("Krohn"), as 49% member, to form Proto-Auto, LLC ("Proto") to manufacture and sell Grand Am Series professional race cars. Despite LCI's majority interest, under Proto's operating agreement the two members were equally represented on its governing board. As one of Krohn's primary obligations under the Operating Agreement, it agreed to provide the services of its manager, Jeff Hazell, as Proto's chief executive officer. LCI and Krohn had a falling out within the first two years of their venture, prompting LCI to sue for dissolution.
Center stage in Lola is Vice Chancellor Noble's analysis of the standard for judicial dissolution of LLCs under Section 18-802 of the Delaware LLC Act, which substantially resembles Section 702 of New York's LLC Law in requiring a showing that it is "not reasonably practicable to carry on the business in conformity with" the LLC operating agreement. Lola makes no new law. Rather, it builds on Chancellor Chandler's analysis in Fisk Ventures, LLC v. Segal, 2009 WL 73957 (Del Ch. Jan. 13, 2009) (read my prior post on Fisk with a link to that decision here), summarized as follows in Lola:
Continue Reading...Delaware Supreme Court Upholds Application of Statute of Frauds to Oral LLC Operating Agreements
Around a year ago I wrote about Delaware Chancery Court's ruling in Olson v. Halvorsen, in which it held that the statute of frauds applies to oral LLC operating agreements. I pointed out that Delaware's LLC law expressly permits oral operating agreements, whereas New York's LLC law defines the operating agreement as a written agreement. To my knowledge, no New York court has yet grappled with the issue.
The Olson ruling was appealed to the Delaware Supreme Court, which yesterday affirmed Chancery Court's ruling (read decision here). In a posting today on his Ideoblog, Professor Ribstein quotes at length from the decision and offers his always-incisive analysis, including his take on how the Olson ruling might play out in a jurisdiction like New York that requires written operating agreements.
It's an important issue for practicing attorneys who help form and give counsel to LLCs, so if you fall into that category -- or even if you don't -- I recommend you read the Professor's post.
Beware Unreasonable Restraints on Alienation When Drafting Shareholder and Operating Agreements
Our English common-law heritage includes what's known as the rule against unreasonable restraints on alienation. Law students first encounter the rule in their property class, where they learn about the abolishment of the feudal "fee tail" which restricted the transfer of real property to a specific line of male heirs. Basically, our laws and public policy strongly favor the right of persons to freely dispose of their property both real and personal. Agreements that place ownership of property in the hands of one person and the right to alienate, i.e., sell or otherwise convey the property, in the hands of another, are unenforceable.
The rule is not absolute. It only prohibits unreasonable restraints on alienation. For instance, where a niece agreed to pay $15,000 to her uncle and aunt for a $100,000 farm that was in the family for generations on condition that, during the uncle's and aunt's lifetimes, the niece wouldn't mortgage the farm or convey it to her husband, a court enforced a reversion clause in the recorded deed giving the property back to her relatives when the niece placed mortgages on the farm that subsequently were foreclosed. The court found it reasonable to enforce the restraint to preserve family ownership of the farm for a limited duration. Moreover, the niece's interest in free alienation was outweighed by her agreement to the restraint in consideration for a drastically reduced price. (Example taken from Alby v. Banc One Financial, 128 P3d 81 [Sup. Ct. Wa. 2006].)
What's this got to do with shareholder and operating agreements?
Continue Reading...Delaware Chancery Court Rulings Interpret Member Rights to Inspect LLC's Books and Records
Last year I wrote about the uncertainty surrounding the rights of members of New York LLCs to gain access to company books and records primarily due to the paucity of court decisions construing the inspection statute, LLC Law Section 1102 (read here). At the time I knew of only two, significant New York cases on the subject, Matter of Hay and Matter of O'Neill, which took markedly different approaches to the problem.
It's been over a year since, and those apparently remain the only two cases of significance. However, in the last few months there have been several, interesting decisions by the Delaware Chancery Court resolving disputes over access to LLC books and records. (HT: Delaware Corporate and Commercial Litigation Blog) The decisions address important issues concerning standing to seek inspection; the meaning of the phrase "books and records" as commonly used in inspection provisions in operating agreements; whether the right of access includes the right to photocopy records; and, perhaps most importantly, the degree to which a court will scrutinize the "proper purpose" basis for the member's inspection demand. Given the similarities between the Delaware and New York statutes, these decisions could be persuasive in resolving books and records actions in the New York courts. Here's a summary:
1. Court may consider evidence outside the operating agreement to determine if party is a "member" entitled to demand access to books and records.
Section 18-305(a)(1) of Delaware's LLC Act gives each LLC "member" defined rights to obtain LLC records, as does its New York counterpart. In a letter ruling in Mickman v. American International Processing, LLC, Del. Ch. C.A. No. 3869-VCP (Apr. 1, 2009), Vice Chancellor Parsons denied the defendant LLC's motion for summary judgment seeking to dismiss a books and records action on the ground that the plaintiff was not listed as a member in the operating agreement and therefore lacked standing under the statute. The plaintiff, who was divorced from one of the two members identified in the operating agreement, submitted an LLC tax return identifying her and her ex-husband as co-owners of a membership interest. She also submitted her ex-husband's Offer in Compromise to the IRS in which he stated under oath that his "only assets are his house . . . and stock in a number of closely held companies owned jointly by Taxpayer and his wife."
Continue Reading...Court Enjoins "Squeeze-Out" Capital Call by Controlling Members of LLC
Baseball has the squeeze play. Majority owners of closely held companies have the squeeze out. It's only fitting, then, that I refer to what happened in the recently decided case, Cooperstown Capital, LLC v. Patton, 2009 NY Slip Op 02277 (3d Dept Mar. 26, 2009), involving a dispute between majority and minority owners of a baseball camp, as the "squeeze-out play."
Martin and Brenda Patton owned land in upstate New York about 20 miles from the Baseball Hall of Fame in Cooperstown. In 2004, they entered into agreements with Cooperstown Capital, LLC to build and operate a baseball camp and hotel on the Patton land. The Pattons contributed the land to Abner Doubleday, LLC ("Abner") in exchange for 35% membership interests in Abner and a second company formed to operate the baseball camp, called Cooperstown All Star Village, LLC ("CASV"). Cooperstown Capital paid $400,000 and gave a $1 million promissory note for 35% interests in the two companies. A third investor, Marco Lionetti, acquired the remaining 30% interests.
The $1 million promissory note was made payable to the Pattons, but the operating agreements designated the payments as operating expenses of the companies and treated Cooperstown Capital's additional capital contributions as credits against the Patton note.
Continue Reading...New York Court Follows Delaware Law to Construe Advancement and Indemnification Provisions of Florida LLC's Operating Agreement
Presiding Justice Jonathan Lippman of the Appellate Division, First Department, who was recently nominated by Governor Paterson to become New York's Chief Judge on the Court of Appeals, has written a significant decision addressing rights of advancement and indemnification for litigation expenses in the limited liability company setting. Ficus Investments, Inc. v. Private Capital Management, LLC, 61 AD3d 1, 2009 NY Slip Op 00263 (1st Dept Jan. 20, 2009).
Not only is the substantive issue in the case -- affirming the right of an LLC member-manager to require the LLC to advance legal expenses defending an action brought by another LLC member -- one of great importance, the decision also reads like a legal travelogue in which a New York court looks to Delaware law to construe an operating agreement of a Florida LLC headquartered in New York.
Private Capital Group (Capital) is a Florida LLC owned 80% by the plaintiff Ficus Investments, Inc. (Ficus) and 20% by defendant Private Capital Management, LLC (Management). Capital buys, manages and sells non-performing mortgages, and was capitalized by loans from Ficus over $300 million. Capital began operations in December 2005. A dispute arose after Management's two owners, Thomas Donovan and Lawrence Cline, transferred about $10 million from Capital to Management. Under Capital's operating agreement, Donovan served as Capital's CEO and Cline as its President. In March 2007, Ficus adopted resolutions taking over Capital's management and it also commenced a lawsuit against Donovan, Cline and Management for breach of fiduciary duty, conversion and unjust enrichment.
Continue Reading...Top 10 Business Divorce Cases of 2008
The nominations are in, the votes are counted, envelope please! Following are my picks for last year's top 10 business divorce cases, all of which were featured in prior posts:
- Tzolis v. Wolff, 10 NY3d 100 (2008), in which the Court of Appeals resolved conflicting First and Second Department decisions on the question whether LLC members can bring derivative actions on the LLC's behalf. They can.
- Matter of Beverwyck Abstract, LLC, 53 AD3d 503 (3d Dept 2008), in which an appellate court upheld a lower court's ruling that the de facto dissolution of an LLC did not terminate the members' fiduciary duty to account for ongoing profits up until formal dissolution.
- Tal v. Superior Vending, LLC, 20 Misc 3d 1103(A) (Sup Ct Westchester County 2008), in which the court crafted an equitable remedy in an LLC dissolution by ordering a return of the petitioner's investment.
- Dingle v. Xtenit, Inc., 20 Misc 3d 1123(A) (Sup Ct NY County 2008), in which the court required a bona fide purpose for a controlling shareholder's dilution of the minority shareholder's interest.
- Caplash v. Rochester Oral & Maxillofacial Surgery Associates, LLC, 19 Misc 3d 1138(A) (Sup Ct Monroe County May 12, 2008), subsequent decision, 20 Misc 3d 1104(A), in which the court upheld the petitioner's standing to seek LLC dissolution after finding that the other member lacked authority to engage the LLC's attorney who had accepted the petitioner's resignation.
- Hellman v. Hellman, 19 Misc 3d 695 (Sup Ct Monroe County 2008), modified, 2009 NY Slip Op 02418 (4th Dept Mar. 27, 2009). involving a corporation owned 50-50 by brothers, in which the court upheld a new company lease executed by the brother who served as president over the other's objection that the lease required board approval.
- Murphy v. U.S. Dredging Corp., 2008 NY Slip Op 31535 (Sup Ct Nassau County May 19, 2008), a valuation proceeding involving shares in a subchapter C real estate holding corporation in which the court applied a discount for built-in capital gains.
- Matter of Youngwall, 2008 NY Slip Op 30811(U) (Sup Ct Nassau County Mar. 14, 2008), adhered to upon reargument in unreported decision dated July 28, 2008, in which the court granted dissolution of an unprofitable LLC and also ruled that a provision in the operating agreement waiving the right to seek judicial dissolution is void as against public policy.
- Ross v. Nelson, 54 AD3d 258 (1st Dept 2008), in which the court enforced the LLC's default statute in upholding a majority vote of the members to remove one of the managers.
- Manitaras v. Beusman, 56 AD3d 735 (2d Dept 2008), in which the court found that an LLC operating agreement's silence on the sale of the LLC's sole asset permitted majority approval under the default statute even though the sale automatically triggered dissolution.
What will 2009 bring? It's not illogical to think that the stress of the economic meltdown will lead to an increase in business divorce. But in my years watching the scene I've never detected any correlation between business cycles and the rate of litigious business break-ups involving closely held companies. If anything, I would lean in favor of the theory that financial success and opportunity in a business create even more incentive for dissension among co-owners. A recent NY Times article pointed out how falling real estate values are impeding marital divorces by eliminating the primary resource for financial settlement. I think a similar phenomenon could be at play with businesses in the current climate, by reducing the upside for a disgruntled owner contemplating a tactical lawsuit designed to induce a buyout.
Appellate Court Finds Operating Agreement "Silent" on Sale of LLC's Sole Asset, Upholds Approval by Majority Vote Under Statute's Default Rule
There have been amazingly few New York appellate court rulings on LLC governance issues since the LLC Law's enactment 14 years ago, and even fewer of any real significance. That's why I'm excited to write about a ruling last month by the Appellate Division, Second department in Manitaras v. Beusman, 56 AD3d 735 (2d Dept 2008), in which the court grappled with a disputed sale of an LLC's sole asset in a fight between majority and minority members. Lawyers who draft LLC operating agreements should pay close attention to the decision and its underlying issues concerning LLC control and the interplay between the operating agreement and statutory default rules.
Kisco Radio Circle Associates, LLC ("Kisco") was formed in 2001 to own and operate a single real property located in Mount Kisco, New York. Anastasios Manitaras held either a 49.74% or 49.89% membership interest (the parties disagreed as to the precise figure) and a group of seven individuals collectively held the remaining majority interest. Manitaras and three other members were the managing members.
In August 2007, counsel for the majority members notified Manitaras of an outside offer to purchase Kisco's property for $5.8 million. Under the operating agreement, the sale of the property was defined as an event triggering the LLC's dissolution and winding up. Manitaras opposed the sale and withheld his consent. The majority members signed written consents authorizing the managing members to enter into a contract of sale.
Continue Reading...Poorly Drafted Disability Clause in Operating Agreement Provides Novel Defense to LLC Dissolution Proceeding
"You can't dissolve the company, you're crazy!"
That more or less sums up one of the most novel defenses I've ever come across in a dissolution proceeding, in which the respondent 50% member of an LLC argued that the petitioning 50% member could not dissolve the company because he was under a mental disability as defined in the parties' operating agreement. Although the defense ultimately failed in this case, there's a lesson to be learned about the proper drafting of disability clauses in shareholder and operating agreements.
The case is Matter of Swett (Factors Walk, LLC) decided several years ago by Monroe County Commercial Division Justice Kenneth R. Fisher. In 2002, Bradford Swett and W. Curtis Barnes as 50/50 members formed a limited liability company known as Factors Walk, LLC to develop and sell real estate consisting of a 75-acre subdivided tract. The operating agreement vested management in the two members equally. It also appears to have included a provision, not fully described in the court's decision, authorizing a member to precipitate voluntary dissolution simply by giving notice to the other member.
In 2005, Swett gave Barnes the prescribed notice following which he commenced a proceeding for judicial supervision of the winding up of the LLC pursuant to LLC Law Section 703(a). The statute authorizes a member to seek such relief for an LLC that has been dissolved either voluntarily or by judicial decree under LLC Section 702.
Continue Reading...Delaware Court Applies Statute of Frauds to LLC Operating Agreement
Limited liability company statutes in Delaware and a number of other states -- but not New York -- expressly authorize oral operating agreements, as does Section 102(13) of the Revised Uniform Limited Liability Company Act (2006). Most if not all states also have a general statute of frauds that bars enforcement of an agreement that cannot be performed within one year unless it is contained in a writing signed by the party against whom the agreement is to be enforced.
What happens when the two statutes collide? Deciding an issue of first impression, the Delaware Court of Chancery has ruled that the statute of frauds applies to an LLC operating agreement under Delaware law. The court therefore dismissed a lawsuit seeking enforcement of an alleged oral operating agreement the performance of which necessarily extended beyond one year. Olson v. Halvorsen, C.A. No. 1884-VCL (Del. Ch. Oct. 22, 2008). Click here to read the decision.
The decisive facts in Olson were largely undisputed. In 1999 the parties founded a hedge fund known as Viking Global. The ownership and administrative structure comprised a Delaware limited partnership and three Delaware LLCs. The plaintiff, Olson, held a 22.5% interest. Short-form operating agreements were signed for the LP and LLCs #1 and #2. Long-form operating agreements for those three entities also were drafted (only one of them was signed), each of which provided that a partner or member who leaves Viking is only entitled to his capital account balance and compensation owed.
LLC #3 had a draft, unsigned long-form operating agreement with an earnout provision not included in any of the other operating agreements. The earnout gave a member varying percentages of the LLC's income over the six years following retirement. The unsigned agreement also contained provisions requiring the remaining members to adjust the profit percentage of the retiring member so as to maintain his economic interest; preventing the remaining members from taking any action to reduce the retiring member's interest; and restricting the remaining members' right to reduce their investments below a specified level.
Continue Reading...WWDD (What Would Delaware Do) With an In Terrorem LLC Dissolution Waiver Clause?
I can't resist asking the above question in the wake of two recent decisions, one from Delaware Chancery Court invoking freedom of contract to enforce an LLC operating agreement's waiver of a member's right to seek judicial dissolution, and the other from New York's Commercial Division refusing on public policy grounds to enforce an operating agreement's in terrorem provision forfeiting the interest of any member who files for judicial dissolution.
The names if not the issues in both cases may sound familiar to regular readers of this blog.
The Delaware case is R&R Capital, LLC v. Buck & Doe Run Valley Farms, LLC, 2008 WL 3846318 (Del. Ch. Aug. 19, 2008) (read decision here). The factions in R&R have been waging a multi-front battle for years, with simultaneous lawsuits in Pennsylvania state and federal courts, New York state court, and most recently Delaware Chancery Court. At issue is control of nine Delaware LLCs that own and operate a number of horse farms. The Russet brothers put up most of the almost $10 million capital but gave 50% member Linda Merritt sole management authority under the operating agreements.
Continue Reading...De Facto Dissolution of LLC Does Not Terminate Members' Fiduciary Duty or Avoid Accounting for Subsequent Profits
An important appellate decision handed down earlier this month holds that LLC members' fiduciary duties to each other do not expire upon the de facto termination of the members' business relationship, but, rather, continue until formal voluntary or involuntary dissolution. As a result, members who continue to do business through the old LLC, or who start up a new competing company prior to formal dissolution of the old LLC, must account to the excluded members for pre-dissolution profits.
The case, Matter of Beverwyck Abstract, LLC, 53 AD3d 903 (3d Dept 2008), has its genesis in a business arrangement between the two individual owners of real estate and mortgage brokerage firms (I'll refer to them as the Brokers) and an Attorney who owned a title abstract firm called Gateway Title Agency, LLC. Previously, the Brokers had teamed up with a different attorney to form Beverwyck Abstract, LLC to perform title work, however that attorney soon withdrew from the firm. In September 2001, the Brokers assigned a 49% membership interest in Beverwyck to Gateway, with the understanding that the Brokers' mortgage company would refer title work to Gateway. Beverwyck had no assets at the time and Gateway made no capital contribution. The fees generated by Gateway's title work would belong to Beverwyck and would then be distributed 1/2 to the Brokers and 1/2 to Gateway. At the same time, the Brokers would arrange for the Attorney to act as the bank closing attorney for the Brokers' mortgage company, with those fees being retained by the Attorney.
Continue Reading...Indemnity Provision Can Tilt the Playing Field in Litigation Between Business Partners
For the business owner without access to the company checkbook, and who therefore must foot his own legal bills, about the only thing worse than litigating a business divorce with a co-owner is seeing her use company funds to pay her lawyer.
Case precedent makes it pretty clear that, in a straightforward dissolution proceeding in which the company is a nominal party rather than an active litigant, neither side has the right to tap company funds for legal fees. But often the dissolution claim by the non-controlling owner is tied to other claims seeking to impose personal liability against officers or managers of the company. When that happens, the defending officer-owners may invoke a contractual right to indemnity including advancement of legal expenses by the company. Alternatively, where the defending officer-owners have board control, they may authorize indemnity and advancement under indemnification statutes.
The latter occurred in Van Der Lande v. Stout, 3 AD3d 261 (1st Dept 2004), where a minority member of an LLC brought a derivative action accusing the majority members of waste, fraud and mismanagement, alongside a separate proceeding to dissolve the LLC. Over the plaintiff's objection the defendant majority members made a substantial capital call upon all members -- including the plaintiff -- to fund the advancement of legal fees in defense of the derivative action. The plaintiff moved for a preliminary injunction to prevent the LLC from compelling him to make contributions. The trial court denied the motion. The appeals court upheld the order under the authority of Section 420 of the New York Limited Liability Company Law, which allows the LLC to advance and pay its members' legal expenses absent a final adjudication that the individual defendants acted in bad faith, were dishonest or personally gained profit to which they were not entitled. "That plaintiff commenced the lawsuit which caused the need for the additional contribution", the court added, "does not constitute an exception to his obligations to the LLC."
Continue Reading...Caplash Redux: 50% Member Cannot Hire Lawyer to Represent LLC in Dispute with Other 50% Member
When 50-50 business partners have a falling out, the ensuing battle for the high ground can lead one of them to take hostile action in the company's name without the other's consent.
Examples of the phenomenon, recently featured in this blog, include the case of Hellman v. Hellman, where the court upheld the authority of a 50% shareholder as president to enter into a lease opposed by the other shareholder, and Sports Legends, Inc. v. Carberry, where the court refused to authorize a lawsuit brought in the company's name by one 50% shareholder against the other.
Then there's Caplash v. Rochester Oral & Maxillofacial Surgery Associates, LLC. About four months ago I wrote about an appellate decision in the Caplash case in which the court reversed a trial court order dissolving a medical practice LLC because of unresolved factual issues concerning the plaintiff's standing to seek dissolution. The issue before the court was whether to give legal effect to the plaintiff's letter to the company resigning his employment, and thereby terminating his LLC membership, where the company's requisite acceptance of the resignation was by letter from an attorney whose authority under the operating agreement to act on the company's behalf was not established. The appellate court sent the case back to the trial court for a hearing to determine the issue.
Since then, there's been a flurry of activity in the Caplash case and a new trial court decision (reported at 19 Misc 3d 1138(A)) which, I'm happy to report, supplies many of the underlying facts missing from the appellate decision. The recent decision, by Justice Kenneth R. Fisher of the Monroe County Supreme Court, Commercial Division, addresses two issues of interest. First, it examines the interplay between the parties' operating agreement and the LLC Law in deciding whether the lawyer engaged by one member with 50% voting power had the authority to accept on the LLC's behalf the other member's resignation. Second, it determines whether the same lawyer could act on the entity's behalf in asserting claims against the resigning member for wrongful competition and other economic injury to the LLC.
Continue Reading...LLC Member's Marital Woes Lead to Loss of Membership Interest
Shareholder agreements for close corporations often include provisions designed to protect the company and its shareholders against involuntary stock transfers or other potentially disruptive court decrees arising from the dissolution of a shareholder's marriage. The same holds true for limited liability company (LLC) operating agreements and their members. Sometimes, as this week's featured case illustrates, such provisions can backfire when a member's marital woes coincide with internal disputes among the LLC's members.
Matter of Madelone (Viscomm Group, LLC), 18 Misc 3d 1131(A) (Sup Ct Albany County 2008), involved an LLC formed in 2003 by three members to engage in advertising and public relations. Initially, the three members -- Whitten, Harrington and Madelone -- each held a one-third interest. Whitten served as manager. Subsequently, a fourth person was brought in as a 10% member, reducing the others to 30% each.
In 2005, when Whitten was experiencing marital difficulties, he proposed certain amendments to the operating agreement which the membership adopted. The amendments required a member who files, or whose spouse files, for legal separation or divorce to sell, and the other members to buy, the membership interest of the member involved in the marital proceedings. The amendments also established a method for computing the purchase price and the payment terms. The following year, Whitten filed for separation from his wife whereupon he relinquished his position as manager and was appointed to a salaried position with the company, only to be reinstated as a member and manager upon reconciling with his wife.
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