Lady Justice

Welcome to another edition of Winter Case Notes in which I clear out my backlog of recent court decisions of interest to business divorce aficionados by way of brief synopses with links to the decisions for those who wish to dig deeper.

And speaking of digging deeper, if you don’t already know, New York’s e-filing system has revolutionized public access to court filings in most parts of the state. The online e-filing portal (click here) allows searches by case index number or party name. Once you find the case you’re looking for, you’ll see a chronological listing with links allowing you to read and download each pleading, affidavit, exhibit, brief, decision, or other filing. No more trips to the courthouse basement to requisition paper files!

This year’s synopses feature matters that run the gamut, from a claimed de facto partnership, to several disputes pitting minority against majority shareholders, to an LLC case in which the court resolved competing interpretations of a somewhat murky operating agreement. Continue Reading Winter Case Notes: De Facto Partnership and Other Recent Decisions of Interest

powerlessAn appellate decision last week sounds alarm bells for minority members of New York LLCs that have no operating agreement and for anyone considering becoming a minority member of an LLC without first having in place an operating agreement.

By the same token, the decision provides opportunities for majority members of existing LLCs without operating agreements to cement and expand their control powers.

Last week’s unanimous decision by the Manhattan-based Appellate Division, First Department in Shapiro v Ettenson, 2017 NY Slip Op 00442 [1st Dept Jan. 24, 2017], affirmed the lower court’s order enforcing an operating agreement signed by two of the LLC’s three co-founding, co-equal members, adopted two years after the LLC’s formation without the signature or consent of the LLC’s third member. Among other features, the operating agreement departed from the statutory default rule by authorizing the reduction of the percentage interest of a member who fails to satisfy a capital call approved by the majority, which is exactly what the two majority members did following their adoption of the agreement, along with eliminating the minority member’s salary. Continue Reading Thinking About Becoming a Minority Member of a New York LLC Without an Operating Agreement? Think Again

Martini2Franklin C. McRoberts, counsel in the Uniondale office of Farrell Fritz and a member of the firm’s Business Divorce Group, prepared this article.


Oh, the things that can happen when the LLC members identified in the company’s operating agreement differ from those identified in official documents submitted to government agencies.

Recently, this blog reported on one case in which the court found in favor of two individuals on their claimed LLC membership interests as evidenced by an application for a food service permit filed by the LLC with the New York City Health Department naming them and the defendant as members, notwithstanding an operating agreement that identified the defendant as the LLC’s sole member. That case involved ownership of a hot dog franchise.

From hot dogs we move to martinis. On an interesting set of facts, Brooklyn Commercial Division Justice Lawrence S. Knipel recently ruled the other way. In the whimsically captioned Cupcake & Boomboom, LLC v Aslani, 2016 NY Slip Op 32310(U) [Sup Ct Kings County Nov. 22, 2016], the outcome was anything but whimsical for the defendant. Justice Knipel discredited documents the LLC submitted to the New York State Liquor Authority (“SLA”) as part of an application to obtain a liquor license, including an operating agreement intentionally misidentifying the members. Instead, the court credited an earlier, inconsistent operating agreement as determinative of the members’ ownership status, thereby reducing the defendant’s claimed interest from 50% to 10%. Continue Reading Operating Agreement Trumps Falsified Liquor License Application In Dispute Over LLC Membership

SushiThe Japanese word “omakase” translates as “I’ll Ieave it up to you” and is used by patrons of sushi restaurants to leave the selection to the chef rather than ordering à la carte.

The minority member of an LLC that operates a high-end Japanese restaurant in Brooklyn featuring omakase service, and who sued for judicial dissolution, recently learned a different meaning of omakase, as in, don’t leave it up to the court to protect you from being frozen out by the majority member when you don’t have a written operating agreement, much less a written operating agreement containing minority-interest safeguards.

The hard lesson learned by the petitioner in Matter of Norvell v Guchi’s Idea LLC, 2016 NY Slip Op 32307(U) [Sup Ct Kings County Nov. 18, 2016], has been taught before, starting most prominently with the First Department’s 2013 decision in Doyle v Icon, LLC and reinforced by that court two years later in Barone v Sowers, holding that minority member claims of oppressive majority conduct including systematic exclusion from the LLC’s operations and profits, in the absence of a showing that the LLC is financially unfeasible or not carrying on its business in conformity with its operating agreement, do not constitute grounds for judicial dissolution under LLC Law § 702. Continue Reading Another Frozen-Out Minority LLC Member’s Petition for Dissolution Bites the . . . Sushi?

Freeze-out2Unless otherwise provided in the operating agreement, majority members of LLCs formed under New York law — and under the LLC laws in most other states — effectively can expel a minority member by implementing a merger with another company owned by the majority members. The so-called freeze-out merger (a/k/a cash-out merger) compels the minority member to accept cash for his or her membership interest in lieu of equity in the surviving entity. The statutes generally protect the frozen-out member to the extent of providing the right to dissent from the merger and to demand a fair-value judicial appraisal.

As best as I can tell, until last month there were exactly four reported court decisions in New York involving challenges to LLC freeze-out mergers, each of which I’ve covered on this blog. In three of them — the Stulman case, the Alf Naman case, and the Slayton case — trial judges rejected various procedural and substantive objections to the mergers by the minority members. In the fourth case (SBE Wall), the trial judge denied a motion to dismiss an action seeking to invalidate a freeze-out merger, but the merger was never enjoined or rescinded and the case eventually settled.

Along comes a fifth case decided last month by Manhattan Commercial Division Justice Charles E. Ramos — who also decided the Stulman case — in which he denied the frozen-out minority members’ preliminary injunction motion seeking to enjoin the merger’s implementation after finding no basis for the minority members’ claim that the merger breached the operating agreement. Huang v Northern Star Management LLC, 2016 NY Slip Op 32194(U) [Sup Ct NY County Oct. 24, 2016]. Continue Reading Court Finds No Breach of Operating Agreement, No Basis to Enjoin LLC Freeze-Out Merger

spaceballs

To Mel Brooks’ collection of hit films, Oscars, and countless other comedic works and awards can now be added the distinction of having his 1987 Star Wars parody, Spaceballs, cited by the decidedly non-comedic Delaware Court of Chancery in support of its construction of an LLC agreement’s provision for advancement and indemnification in a lawsuit arising from a soured business relationship between the majority and minority members of a Delaware company formed in 2007 called Quivus Systems, LLC.

The transcript decision by Vice Chancellor Tamika Montgomery-Reeves in Harrison v Quivus Systems, LLC, C.A. No. 12084-VCMR [Del Ch Aug. 5, 2016], granted summary judgment on a claim for advancement of legal expenses in favor of the plaintiff Harrison, a principal of Quivus’s 45% member and its former CEO who was terminated in 2014 and then sued the following year in Washington D.C. Superior Court by the 55% member, Soroof International Corp., allegedly for mismanagement, incompetence, and looting.

Harrison filed his Chancery Court action after Soroof rejected his demand for advancement for all expenses, including legal fees, he incurred and would continue to incur in defending against all but one count in the D.C. action, as well as in prosecuting his counterclaims in the D.C. action. Continue Reading When Will Then Be Now? Court Construes LLC Agreement’s Advancement Provision With An Assist From Spaceballs

Good faithIf, as appears likely, the drafters of the LLC membership interest repurchase provisions at issue in Saleeby v Remco Maintenance, LLC, 2016 NY Slip Op 31447(U) [Sup Ct NY County July 25, 2016], thought they were helping the company avoid the possibility of litigation over the value assigned to the outgoing member’s interest, as it turns out they were sorely mistaken.

Poorly drafted or not, the LLC’s managers also likely did themselves and the company no favor by assigning a zero-dollar value to the membership interest of the terminated member in the Saleeby case, and by muddling the timing of the company’s exercise of its repurchase option.

Here, in a nutshell, is what happened in Saleeby as described in Manhattan Commercial Division Justice Anil C. Singh’s decision: In 2005, the defendant company Remco Maintenance, a New York based Delaware LLC, hired plaintiff Saleeby as its President and CEO. Saleeby’s employment agreement granted him a 7.5% Class B membership interest which fully vested by the time he was terminated without cause in February 2012. Over the next two years, Saleeby and the company attempted without success to negotiate their dispute over his termination, severance, vacation pay, and rights to unemployment insurance. In 2014, the company informed Saleeby that in 2013 it had exercised its option under the LLC Agreement to repurchase his membership units at a “fair market value” of zero dollars. Saleeby subsequently filed suit against the LLC for breach of contract and conversion. Continue Reading Good Faith Trumps Sole Discretion in LLC Agreement’s Repurchase Provision

consentThe pick-your-partner principle is universally embedded in the default rules of limited liability company enabling acts, including Sections 601 through 604 of the New York LLC Law which permit free assignment of distributional and other economic rights appurtenant to a membership interest but require the other members’ consent before an assignee is granted full member status with voting and other rights associated with membership in an LLC.

The distinction between a “mere” assignee versus a transferee with member status can become a battle ground when a putative LLC member who received his, her or its interest by assignment brings legal action against the LLC’s managers for dissolution, access to books and records, or asserting derivative claims on behalf of the LLC. That’s because by statute and/or common law, the suing party’s requisite legal standing to assert such claims depends on having member status.

A recent decision by Manhattan Commercial Division Justice Saliann Scarpulla in MFB Realty LLC v Eichner, 2016 NY Slip Op 31242(U) [Sup Ct NY County June 24, 2016], in which she dismissed derivative claims by a mere assignee of LLC interests, starkly illustrates the distinction and the importance of compliance with the LLC agreement’s provisions for bestowing member status on assignees. Continue Reading Operating Agreement’s Two-Step Consent Provision Foils Assignment of LLC Member Interest

CunninghamNew Hampshire lawyer John Cunningham eats, sleeps and breathes limited liability companies.

Seriously, John has carved out for himself a niche practice as one of the foremost experts in the country on the formation of limited liability companies and the drafting of LLC operating agreements.

He shares his knowledge through his many lectures and publications, including his leading LLC formbook and practice manual, co-authored by Vernon Proctor, called Drafting Limited Liability Company Operating Agreements published by Wolters Kluwer, and his highly informative blog Cunningham on Operating Agreements. John also chaired the committee that wrote the New Hampshire Revised LLC Act enacted in 2013.

From a business divorce perspective, management deadlock is a recurrent problem and precipitator of litigation for LLCs with two equal members. I didn’t fully grasp the potential magnitude of the problem, however, until I read John’s recent article in the Wealth Counsel Quarterly called “Avoiding Deadlocks in LLC Operating Agreements” in which he cited an IRS statistic that 25% of all LLCs nationwide consist of two members. My own experience jibes with John’s article’s observation, that “the members of most two-member LLCs are equal in voting and profit shares,” and that

For all of these LLCs, the issue of deadlock is major. Even in the best two-member LLC, it is likely that deadlock issues will eventually arise, and can destroy an otherwise promising LLC.

Continue Reading John Cunningham on Avoiding Deadlock in Two-Member LLCs

Molk_Peter

Peter Molk, an Assistant Professor of Law at Willamette University College of Law and a rising young star in legal academia, has written a groundbreaking article entitled How Do LLC Owners Contract Around Default Statutory Protections? slated for publication in the University of Iowa College of Law’s Journal of Corporation Law and currently available here on SSRN.

The article also is the subject of my podcast interview of Professor Molk embedded at the bottom of this post.

Professor Molk’s article deserves attention because it asks and attempts to answer based on empirical evidence a vital question: Is the freedom of contract promoted by the LLC statutes’ default rules being used as theory would predict, to promote economic efficiency and to craft more efficient owner protections? In fact, his study finds that LLCs with more vulnerable owners adopt fewer owner safeguards, suggesting that contractual freedom may be used by LLC controllers opportunistically rather than to achieve efficiencies.

Professor Molk’s first-of-its-kind study tests theory with the reality of what is actually happening in the world of LLC operating agreements. He does this by carefully examining almost 300 operating agreements of LLCs involved in litigated cases mostly in Delaware but also in New York, looking for provisions that either weaken or strengthen owner protections granted by the statutory default rules. The patterns his study finds have a direct impact on business divorce practitioners and also should influence choice of entity decisions and the drafting of agreements by practitioners involved in entity formation.

In his own words, here’s the abstract of Professor Molk’s article:

Limited liability companies are built on the idea of contractual freedom. Unlike other business organization forms, most owner protections apply only by default to LLCs, which are free to waive or modify them as desired. This freedom promises economic efficiency if parties are sophisticated but raises the potential for opportunism by relatively more sophisticated managers and majority owners. While companies ranging from small landscape firms to Chrysler and Fidelity organize as LLCs, remarkably little is known about whether or how LLCs use this contractual flexibility.

I analyze the operating agreements of 283 privately owned LLCs organized under Delaware and New York law to determine when and how parties alter default provisions. I find widespread use of LLC statutes’ flexibility to decrease default owner protections, as well as widespread adoption of substitute owner protections that do not apply by default. There is little evidence, however, that the contractual freedom is used to craft more efficient owner protections. Instead, using a proxy for owner vulnerability, I find that LLCs with more vulnerable owners adopt significantly fewer owner safeguards, suggesting that contractual freedom may be used more for opportunism, not efficiency.

Professor Molk has much, much more to say on the subject in my podcast interview which I hope you’ll listen to and enjoy.