shutterstock_121625548It’s not that I get nostalgic about derivative lawsuits (or Oldsmobiles), it’s just that it feels like we’re in a brave new world when it comes to adapting hoary corporate doctrine to that unincorporated upstart known as the limited liability company.

The clash between old and new looms in a derivative action concerning an LLC pending before Erie County Commercial Division Presiding Justice Timothy J. Walker called Univest I Corp. v Skydeck Corp., Index No. 2014-811644. The case stems from a dispute between the 50% managing member (BDC) and 50% non-managing member (Univest) of 470 Pearl Street, LLC, which was formed in 2004 for the purpose of acquiring for future development a parking lot in Buffalo, New York. Pending the development, BDC and Univest agreed to lease the parking lot to a BDC affiliate known as Skydeck Corp. The lease granted 470 Pearl the right to terminate the lease on 60-days notice.

In 2014, Univest, acting in 470 Pearl’s name, issued a termination notice to Skydeck under authority of an unusual provision in 470 Pearl’s operating agreement that gave either member the unilateral right “to cause 470 Pearl to terminate” the Skydeck lease. Two lawsuits followed Skydeck’s refusal to vacate. In the first, Justice Walker granted Univest a declaratory judgment upholding its termination notice and ordering Skydeck, pending further order, to pay an increased monthly rent (read amended complaint here and the court’s order here).

Shortly afterward, Univest commenced a derivative summary eviction proceeding on behalf of 470 Pearl, naming both Skydeck and BDC as respondents (read petition here). Now, let me pause the story for a moment. I’m not a landlord-tenant lawyer. If you’d asked me, before I looked into the Univest case, whether a non-controlling, non-managing corporation shareholder or LLC member could bring an eviction proceeding against the corporation’s or LLC’s tenant, I’m sure I would have guessed “no” for at least two reasons. First, I would have assumed the governing statute in Article 7 of the Real Property Actions and Proceedings Law somehow limits standing to seek relief to the owner or its authorized agent. Second, evicting a third-party tenant strikes me as quintessential management action. Imagine the chaos if any minority owner of a real estate operating company could take it upon themselves to launch eviction proceedings. But I would have guessed wrong. Gorbrook Associates, Inc. v Silverstein, 40 Misc 3d 425 [Dist. Ct. Nassau County 2013], a case of apparent first impression, held that a non-controlling, minority shareholder may bring derivatively an eviction proceeding.  Continue Reading Not Your Father’s Derivative Action

Hardcore students of business divorce will remember Pappas v. Tzolis as a roller coaster ride through the trial and appellate courts in which, ultimately, New York’s highest court dismissed claims against a 40% LLC member who bought out his 60% co-members for $1.5 million, allegedly while concealing from them that he already had lined up a buyer for the LLC’s sole asset — a 49-year lease on a Manhattan commercial property — for $17.5 million. The court held that a provision in the buy-out agreement, stating that the buying member “has no fiduciary duty to the . . . sellers in connection with [the sales of their interests],” was a complete defense to the sellers’ claims that the buyer breached a duty to disclose the alleged $17.5 million offer. (Read here my post about the Court of Appeals’ November 2012 ruling.)

Pappas was decided on a pre-answer, pre-discovery motion to dismiss the complaint. The procedural posture required the court to assume the truthfulness of the complaint’s factual allegations. The defendant 40% member, Steve Tzolis, did not have to admit or deny that, in fact, he secretly had negotiated a $17.5 million sale of the LLC’s lease to a major real estate developer, Extell, before buying out his partners for $1.5 million. All we outside observers knew for certain was that the $17.5 million sale occurred about seven months after the buy-out of the member interests.

At least some of the mystery has now been revealed, courtesy of a subsequent lawsuit brought by one of the two disappointed sellers, Steve Pappas, against a law firm that, according to Pappas, represented him and/or the LLC in connection with the buy-out agreement while simultaneously assisting Tzolis’ secret negotiations to sell the lease to Extell. Our informational gain is of little comfort to Pappas, whose case against the law firm recently was thrown out as an impermissible end-run around the preclusive effective of the Court of Appeals’ ruling in the prior case. Pappas v Schatz, 2014 NY Slip Op 30946(U) [Sup Ct NY County Apr. 9, 2014]. Continue Reading Pappas v. Tzolis: A Revealing Epilogue

I’m pleased to present my fifth annual list of picks for the past year’s ten most significant business divorce cases. This year’s crop, five of which are appellate decisions, includes highly interesting and important rulings on a variety of issues in dissolution, buy-out, appraisal and fiduciary breach cases involving closely held corporations, partnerships and limited liability companies. All ten were featured in this blog previously; click on the case name to read the full treatment. And the winners are:

  1. Kagan v. HMC-New York, Inc., 94 AD3d 67, 2012 NY Slip Op 01514 (1st Dept Feb. 28, 2012), in which a closely divided panel of the Appellate Division, First Department, applied Delaware law to dismiss claims for breach of fiduciary duty against LLC managers based on the operating agreement’s provision limiting manager liability.
  2. Matter of Grande’ Vie, LLC, 93 AD3d 1281, 2012 NY Slip Op 02190 (4th Dept Mar. 23, 2012), another appellate decision, where the court reversed a lower court order and compelled arbitration over a disputed appraisal notwithstanding language in the buy-sell agreement making the appraisal “binding.”
  3. Matter of Clever Innovations, Inc., 94 AD3d 1174, 2012 NY Slip Op 02536 (3d Dept Apr. 5, 2012), a case of dueling dissolution petitions by 50/50 shareholders in which an upstate appellate panel affirmed an order compelling a buy-out of the shareholder who’d filed a BCL 1104-a petition as an oppressed shareholder by the shareholder who’d filed a BCL 1104 petition for deadlock. Continue Reading Top Ten Business Divorce Cases of 2012

The roller-coaster ride known as Pappas v. Tzolis came to an end last week when New York’s highest court threw out a lawsuit by two disappointed sellers of LLC membership interests who accused the third, purchasing member of not disclosing at the time of sale that he already had lined up a buyer for the LLC’s sole asset at a huge premium. Pappas v. Tzolis, 2012 NY Slip Op 08053 (Ct App Nov. 27, 2012).

The Court of Appeals’ decision, enforcing a fiduciary waiver provision in the membership transfer agreement, follows in the wake of the same court’s rulings last year in the Centro and Arfa cases, likewise rejecting fiduciary breach claims between business co-owners in the face of releases given in connection with the challenged transactions. (Read here my post on the Centro and Arfa cases.) The Centro-Arfa-Pappas trilogy sends a clear message that, at least where the co-owners’ relationship is no longer one of unquestioning trust, a fiduciary’s assertions surrounding the challenged transaction cannot be blindly relied upon to overcome a contractual release or waiver of fiduciary duty. Continue Reading Pappas Saga Ends, Court of Appeals Upholds Fiduciary Waiver in LLC Buy-Out Agreement

Three-member LLC’s sole asset is long-term commercial lease. 40% Member A buys out 60% Members B and C for $1.5 million. Six months later, Member A sells lease to third party for $17.5 million. Members B and C bring damages suit against Member A for breach of fiduciary duty of disclosure, alleging that Member A secretly was negotiating sale of lease when he bought out Members B and C. Member A defends suit based on express waiver of fiduciary duty in buy-out agreement and on operating agreement’s provision permitting members to engage in competitive business ventures. Who wins?

That’s the question confronting the New York Court of Appeals, the state’s highest court, in Pappas v. Tzolis, No. 193. Earlier this month, the Court of Appeals heard oral argument of the defendant member’s appeal from a split decision by the Manhattan-based Appellate Division, First Department, permitting the complaining members’ lawsuit to proceed after it had been dismissed by the trial court.

The Pappas appeal presents the latest chapter in the ongoing, doctrinal clash of two, fundamentally different notions of the relations and duties among co-owners/fiduciaries of closely held business entities when they enter into buy-out agreements and otherwise formally reconstitute ownership and management rights. The outcome in Pappas also may mark the dénouement of a running debate between the Court of Appeals and the First Department, in which the inferior appellate court more often than not has come down on the side of fiduciary enforcement notwithstanding contractual outs, while the superior court in recent decisions has shown a greater willingness to enforce releases and other contractual waivers of fiduciary duty negotiated by sophisticated business partners with the assistance of counsel. Continue Reading Does Waiver Trump Fiduciary Duty? Court of Appeals Hears Argument in Pappas v. Tzolis

A lawsuit between the owners of an upper east side Manhattan “gentlemen’s club” called Sapphire, involving charges of self-dealing and financial abuse by the managing partner, led to an interesting but not surprising decision earlier this month, holding that a member of LLC #1 which, in turn, is a member of LLC #2, lacks standing to seek judicial dissolution of LLC #2. JG Club Holdings, LLC v. Jacaranda Holdings, LLC, 2012 NY Slip Op 50724(U) (Sup Ct NY County Apr. 20, 2012).

The club, owned and operated by a New York limited liability company called Jacaranda Club, LLC (“Sapphire”), arose from the ashes of the notorious Scores strip club that closed down at the same location in 2008. According to its December 2008 Operating Agreement (read here), Sapphire started operations with two members: Jacaranda Holdings, LLC (“Jacaranda”) as the 51.1% managing member and TDK Holdings, LLC (“TDK”) as the 48.9% non-managing member. TDK with Jacaranda’s consent subsequently assigned its entire membership interest to JG Club Holdings, LLC (“JG”) whose membership included Jeffrey Wasserman (the “JG Controlling Member”) as the managing majority member, and two non-managing minority members, GRKS II LLC and DZ Ventures LLC (collectively, the “JG Minority Members”).

In December 2010, the JG Controlling Member brought suit in JG’s name (read complaint here) against Jacaranda, its principal, Michael Talla, and a separate company controlled by Talla called Club at 60th St., Inc. (“60th St.”) from which Sapphire leased its club facility, asserting a number of individual and derivative claims on Sapphire’s behalf. The suit’s gravamen is that Talla/60th St. charged Sapphire grossly excessive rents and also used Sapphire’s funds to pay the defendants’ separate loan obligations. The complaint did not seek judicial dissolution of Sapphire.

Continue Reading Can a Member of a Member of an LLC Sue to Dissolve the LLC?

Toward the close of its 2010-11 term, the New York Court of Appeals (the state’s highest court) issued a pair of decisions in the Centro and Arfa cases that cast a dark cloud over a line of precedent established by the Manhattan-based Appellate Division, First Department, that had refused to enforce releases or fiduciary waivers given by sellers of interests in closely held businesses who later brought suit against the purchasers/controlling owners for concealing material information affecting the buy-out price, such as an impending deal to sell the company assets to a third party at a much higher valuation.

The best known of the First Department cases, Blue Chip Emerald v. Allied Partners, 299 AD2d 278 (2002), and its progeny including Littman v. Magee, 54 AD3d 14 (2008), broadly suggested that a fiduciary can never contractually relieve itself of its duty of full disclosure by withholding material information the non-controlling owner needs in making its decision to enter into the buy-out agreement. In Centro and Arfa, however, the Court of Appeals expressly disagreed with the First Department cases insofar as they would preclude a sophisticated party from giving a release or waiver in favor of its fiduciary as part of a transaction where the party understands that the fiduciary is acting in its own self-interest and the release or waiver is knowingly entered into. (Read here my post on the Centro and Arfa decisions.)

Anyone who thought Blue Chip was down for the count would be mistaken. Last week, over a vigorous two-judge dissent, a three-judge majority in Pappas v. Tzolis, 2011 NY Slip Op 06455 (1st Dept Sept. 15, 2011), unabashedly wielded Blue Chip to salvage a lawsuit brought by two owners of a realty company who, after selling their LLC membership interests to the third member under an agreement containing a fiduciary waiver, brought suit claiming the buyer intentionally concealed from them an impending deal to sell the company’s sole asset to an outside buyer at a spectactularly higher valuation.

Continue Reading The Rise and Fall and Rise of Blue Chip: Fiduciary Duty Trumps Waiver in Latest First Department Decision

A limited liability company named Ocelot Capital Management, LLC made some new law last month on a narrow but interesting issue: Can the majority member of a manager-managed New York LLC bring a derivative action on its behalf when the manager position is vacant, without alleging either a prior demand upon the manager or that such demand would be futile?

The question drew a negative answer from New York County Commercial Division Justice Bernard J. Fried, who consequently dismissed the derivative claims in Eldan-Tech, Inc. v. Ocelot Capital Management, LLC, Memorandum Decision, Index No. 651101/10 (Sup Ct NY County Oct. 29, 2010).

The dispute in Ocelot begins with a $350,000 promissory note made by Isaac Hershkovitz in favor of Ocelot Portfolio Holdings, LLC (“OPH”) given in partial payment for Hershkovitz’s purchase from Holdings of the latter’s ownership interest in another real estate holding company known as OCG VI.  According to its operating agreement, OPH is a manager-managed LLC whose membership interests are held 80% by plaintiff Eldan-Tech, Inc. (“Eldan”) and 20% by defendant Ocelot Capital Management, LLC (“OCM”).  OCM, which was OPH’s sole manager, is wholly owned by Rachel Arfa and her husband.  At that time Arfa also was the sole officer and director of Eldan.

Continue Reading May Majority Member of Managerless Manager-Managed LLC Maintain Derivative Action?

The question posed by this post’s title derives from an unpublished decision earlier this month in a case called Pappas v. Tzolis, Mem. Dec., Index No. 601115/09 (Sup Ct NY County Mar. 3, 2010).  The case involves a real estate LLC whose operating agreement included a frequently used "Other Activities" clause expressly authorizing the members to engage in competitive business ventures.  One member bought out the other two, allegedly while he was secretly negotiating with an unrelated outside buyer of the LLC’s sole asset.  The sale took place about six months after the member buyout for a price far in excess of what the former members received.  The court dismissed the former members’ complaint alleging that the failure to disclose the negotiations with the outside buyer breached fiduciary duty, holding that the Other Activities clause eliminated fiduciary duty.

Pappas raises several interesting questions, the first of which has two parts: (a) what law determines fiduciary obligations in a Delaware LLC whose operating agreement expressly provides that it is to be governed by New York substantive law, and (b) why would parties form a Delaware LLC but opt to apply New York law?  Second, under either state’s law, can the members completely eliminate a fiduciary duty of disclosure of the sort alleged in Pappas?  Third, did the specific language of the operating agreement’s clause permitting competition eliminate such duty?  Complicated issues all, the answers to which could occupy a law review article.

Continue Reading Does Operating Agreement’s Clause Permitting Competitive Activities Eliminate Member’s Fiduciary Duty to Disclose Negotiations to Sell LLC’s Assets Before Buying Out Co-Members?

 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, 71 AD3d 646, 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 Tzolis No Solace for Proponent of LLC Member Expulsion