New York Business Divorce : New York Business Dissolution Lawyer & Attorney : Farrell Fritz Law Firm : Buy-outs, Shareholder Disputes : New York, NY

The agreement contains two other provisions critical to the lawsuit. One states that if the partnership fails to make installment payments to the retired partner for six months, the entire amount due the retired partner accelerates and becomes due and payable as a lump sum. Another authorizes the partnership to offset estimated Withdrawal Obligation payments by the retired partner against amounts due the retired partner. 

Difficulties began even before Speiser's retirement at year-end 2007, including an aborted effort by the two remaining partners to dissolve the partnership. In 2008, after Speiser retired, the partnership filed an action against Speiser accusing him of soliciting firm clients and employees even before he left the firm, and of breaching an oral agreement to help transition the firm clients that he handled. The partnership also claimed that Speiser's failure to pay his Withdrawal Obligation, which it calculated to be $688,000 on account of the clients Speiser took with him, relieved it of its obligation to pay retirement benefits which Speiser calculated to be in excess of $1.4 million.

Speiser countered that, based on correspondence from the partnership in February 2008, the partnership "elected" to offset Speiser's entire Withdrawal Obligation against the entire amount of retirement payments due Speiser, thus rendering the partnership presently liable for the entire differential based on the partnership's failure to make payments to him over six months.

Speiser moved for summary judgment dismissing the partnership's claims against him and in his favor on his counterclaims. The partnership cross moved for summary judgment in its favor. The court's decision (read here), by Manhattan Supreme Court Justice Judith J. Gische, denied all of the parties' motions with the exception of granting summary judgment of liability for Speiser on a collateral claim for compensation due him for the period prior to his retirement.

Justice Gische rejects Speiser's reliance on the partnership's supposed "election" to offset the entire Withdrawal Obligation against the entire retirement payment obligation. Here's what she says:

Nothing in the partnership [agreement] limits the plaintiffs to having to make a one time, binding and unchangeable election to offset the Withdrawal Obligation against any amount due the Withdrawing Partner. Even if, as Speiser claims, the plaintiffs offset the Withdrawal Obligation against the monies to be paid to Speiser, the correspondence contains statements of account only through March 1, 2008. The letter does not elect to make these offsets indefinitely, on an ongoing basis. Furthermore, had it been the parties' intention that once the plaintiffs elect to offset these monies one against another any such election is irrevocable, then such language would have been included in the Partnership Agreement [citation omitted]. There being no such condition in the Partnership Agreement, plaintiffs have raised a triable issue of fact regarding whether they elected to offset monies and whether it was a one time or ongoing basis.

Justice Gische likewise rejects the partnership's argument that Speiser's failure to pay his entire $688,000 Withdrawal Obligation is a material breach relieving it of its obligation to pay Speiser post-retirement benefits, reasoning as follows:

This claim is supported by arguments that if a retiring partner services firm clients after he leaves (i.e. takes business) but does not pay his withdrawing obligation, Firm billables decrease and the Firm cannot afford to pay him Post-Retirement benefits. While this may be the practical effect of a retiring partner not paying his Withdrawal Obligation, it is clear from the Partnership Agreement that the obligation to pay Post-Retirement benefits is separate from the retiring partner's obligation to pay the Withdrawal Obligation. Therefore, Speiser's breach, if any, in paying the Withdrawal Obligation does not relieve the Firm's own, separate, obligation to pay the Post-Retirement benefits.

The decision also notes the parties' disagreements over the calculations of the Withdrawal Obligation and the post-retirement benefits.

According to the court's website, the case is set for mediation next month.

Showell v. Pusey, C.A. No. 3970-VCG (Del Ch Sept. 1, 2011)

Showell also involves a three-partner accounting firm, organized as a Delaware LLC, in which the petitioner, Glenn Showell, held a 29% interest. In early 2007, Showell and partner William Pusey, who held a 61% interest in the firm, agreed that Showell should retire to help with his family's trailer park business. By the time Showell left the firm, however, there was no agreement on the amount to which he was entitled upon his retirement.

The firm's LLC agreement does not allow for the withdrawal or resignation of its members. A supplemental written agreement addresses repurchase of a member's interest upon a "Retiring Event" defined as certain events not including a voluntary retirement. A qualified Retiring Event (such as death and bankruptcy) triggers a repurchase at a price equal to the member's "Net Equity" defined as his proportionate share of "the amount that would be distributed to such a Member in liquidation of the Company."

Showell petitioned the Delaware Chancery Court for a determination of the amount due him for his interest, which he argued should be the going concern "fair value" under the default rule for distributions upon resignation contained in §18-604 of the Delaware LLC Act. The statute, which is similar to New York LLC Law §509, provides as follows:

Except as provided in this subchapter, upon resignation any resigning member is entitled to receive any distribution to which such member is entitled under a limited liability company agreement and, if not otherwise provided in a limited liability company agreement, such member is entitled to receive, within a reasonable time after resignation, the fair value of such member's limited liability company interest as of the date of resignation based upon such member's right to share in distributions from the limited liability company.

The firm and the remaining members argued that, because the LLC agreement forbids member withdrawal, and because the supplemental agreement makes no provision for payment to a member who voluntarily retires as opposed to other defined Retiring Events, Showell was not entitled to any payment. Alternatively they argued that Showell is entitled to no more than his share of the firm's liquidation value.

In his decision (read here), Vice Chancellor Sam Glasscock, III finds that Showell's argument for application of §18-604 is negated by the prohibition against member withdrawal expressly stated in the LLC agreement. He also notes the omission of voluntary retirement as a defined Retiring Event in the supplemental agreement. On the other hand, he continues, it was undisputed that Showell and Pusey, representing 90% of the firm's membership interest (i.e., more than the percentage required to amend the LLC agreement) had in fact agreed that Showell could retire and that the firm would purchase his interest. Therefore, VC Glasscock concludes, in order to "harmonize" Showell's agreed retirement with the intent of the parties as expressed in their written agreements, the purchase price for Showell's interest should be liquidation value as defined in the supplemental agreement. VC Glasscock explains:

Because the Agreements read as a whole evidenced careful planning for the obligations of [the firm] upon a member's retirement, I reject Showell's argument that the "default" provision of 6 Del. C. §18-604 should apply. The members (including Showell), in creating the Operating Agreement and Supplemental Agreement, did contemplate the effects of a retirement and provided specifically for the obligations of [the firm] upon such an event happening. The statute itself provides that "fair value" is the measure of the LLC's obligation to a withdrawing member only if the Agreement fails to provide otherwise. Because [the firm] permitted Showell to retire despite the fact that his reason for retiring did not constitute a "Retiring Event," and because I find that an agreement existed to purchase his interest, the measure of [the firm's] obligation is as set out in the Supplemental Agreement, Article 1.1 as though a Retiring Event had occurred. That obligation is based on the liquidation value of the Company as set out in the Supplemental Agreement at Article 1.6, and payment is due on the schedule provided and at the interest rates provided in the Supplemental Agreement, Article 1.1(d).

Showell's appraisal expert testified that Showell's 29% share of the firm's fair value as a going concern including good will was $281,000, as opposed to its liquidation value of $65,000. The firm's expert testified, and VC Glasscock agrees, that the good will component of the fair value appraisal, including the firm's client list, is of "minimal value" because the LLC agreement lacks a provision prohibiting a retiring member from competing with the firm. "Therefore," VC Glasscock writes, "even if 'fair value,' rather than liquidation value, were to be used to calculate the amount to which Showell is entitled here, the net difference would be minimal."

In other words, according to the court's assessment of the valuation evidence, the dispute over application of the default statute's fair value standard versus the agreement's provision for liquidation value is a tempest in a teapot.

Demand Requirement Adopted in Evans v. Perl

New York County Supreme Court Justice Judith Gische was the first to weigh in with her ruling in Evans v. Perl, 19 Misc3d 1119[A] (Sup Ct NY County 2008).  The plaintiff in Evans asserted derivative claims for an accounting on behalf of a number of LLCs.  Defendants moved to dismiss for failure to make or allege a pre-action demand.  Plaintiff countered that demand is not necessary in the LLC context and that, in any event, demand would have been futile because the LLCs and the controlling defendant "have no real separate identity."

Judge Gische sided with defendants, concluding that LLC derivative suits should be subject to the same demand/futility requirements applicable to corporations, explaining as follows:

The court rejects [plaintiff's] argument that, as a matter of law, no prior demand is necessary before a derivative action can be brought against an LLC. This argument rests primarily on the fact that there is no explicit requirement for a demand in the LLC statute.  There is, however, no explicit right to bring a derivative action contained within the LLC statute either.

As the Court of Appeals held in the recent case of Tzolis v. Wolff (10 NY3d 100[2008]) there is a common law right to bring a derivative action against an LLC. See also: Bischoff v. Boar's Head Provisions Co. Inc., 38 AD3d 440 (1st Dept. 2007).  The common law underpinning of a derivative action is that a faithless trustee refused to bring the action on behalf of the business entity his or herself. Tzolis v. Wolff, supra.  Thus the requirement of a demand prior to the institution of derivative litigation is a necessary element of the claim.  It is predicated on basic principles of business governance, i.e., that those entrusted with the management of a corporation who have the primary responsibility for acting in the name of the corporation are often in the best position to correct alleged abuses without resort to the courts.  BCL §626; Barr v. Wackman, 36 NY2d 371 (1975).  There are no cases expressly addressing the issue of the prior demand in the context of derivative actions against an LLC. This is most likely because the right to even bring a derivative action at all was only recently established by the Courts of Appeals.  Tzolis v. Wolff, supra.  Borrowing, however, from the developed law applicable to derivative actions in a corporate context, the same policy considerations apply and the law applicable to LLCs should be consistent.  Thus this court holds that before bringing a derivative action against an LLC for an accounting, the member must make a prior demand on the LLC or otherwise make a showing that such a demand would have been futile.

Justice Gische did not dismiss the claims, however, finding that under the circumstances demand would have been futile.

Contemporaneous Ownership Requirement Adopted in Billings v. Bridgepoint Partners, LLC

Section 626(b) of the Business Corporation Law and Section 121-1002(b) of the Revised Limited Partnership Act require that the plaintiff in a derivative action be a shareholder/limited partner of the corporation/limited partnership at the time of the transaction of which he or she complains, and at the time of bringing the action.  The same rule now applies to LLC derivative actions, according to a decison earlier this month by Erie County Commercial Division Justice John M. Curran in Billings v. Bridgepoint Partners, LLC, 2008 NY Slip Op 28351 (Sup Ct Erie County Sept. 19, 2008).

The plaintiff in Billings formed an LLC with two other members in November 2005.  In April 2007, the LLC terminated the plaintiff's employment alleging violations of the operating agreement.  A week later, the plaintiff claimed that his interest in the LLC had been constructively terminated and thereupon exercised his rights to withdraw from the LLC and redeem his membership interest for cash payment under the operating agreement's terms.  Plaintiff later brought suit asserting claims against the LLC for breach of the operating agreement along with derivative claims against the other members for improper self-dealing, waste and diversion of LLC assets. 

The defendants moved to dismiss the derivative claims on the ground plaintiff was not a member of the LLC at the time he commenced the action.  As in Evans, Justice Curran agreed that the common law applicable to LLCs should be guided by the logic and policies underlying the statutory limitations on derivative actions by shareholders and limited partners, writing as follows:

[T]his Court must follow the guidance in Tzolis which requires an analysis of whether there was a contemporaneous ownership requirement at common law and/or a requirement for a demand. . . . The Court is persuaded that the Court of Appeals has provided controlling authority under the common law to impose a contemporaneous ownership limitation upon the right to sue derivatively in the limited liability company context.  In Hanna v. Lyon (179 NY 107 [1904]), the Court of Appeals held:

But while the plaintiff Hanna was a stockholder at the time of the commission of the acts of which he complained, he had ceased to be a stockholder at the time of the commencement of the action, and hence was without authority to maintain it.  His rights as a stockholder had passed to the subsequent purchaser of the stock, and the Appellate Division was, therefore, right in reversing the judgment as to him and dismissing the complaint. (179 NY at 110-111).

Accordingly, this Court concludes that a member of a limited liability company may sue derivatively, but that such a member seeking derivative relief must have been a member at the time of the offending conduct and at the time the action was commenced.  Any other conclusion would be contrary to the analyses in Tzolis and Hanna.  Moreover, a contrary conclusion would provide rights to members of limited liability companies beyond the rights afforded under New York law to shareholders of business corporations and limited partners.  There is no common law or statutory authority supporting any such conclusion.

The plaintiff in Billings affirmatively alleged that he withdrew from the LLC in April 2007, prior to bringing the action.  The operating agreement also provided that a member who withdraws has only a right of future payment.  Justice Curran accordingly concluded that the plaintiff lacked standing to assert derivative claims.

The defendants in Billings also relied on plaintiff's failure to allege demand or demand futility in his complaint.  Stating that the court "need not reach the issue of whether a demand is required," Justice Curran nonetheless observed in dicta that, "given the conclusion with respect to contemporaneous ownership requirement, this Court can see no basis upon which to conclude that a demand limitation should not be imposed in the limited liability context similar to what is imposed in the business corporation and limited partnership contexts."

Once Tzolis breached the derivative action barrier, rulings such as those in Evans and Billings, adopting the same limitations on standing as in the corporation and limited partnership setting, were inevitable.  Will courts in LLC derivative actions also adopt common law counterparts to the BCL and RLPA rules governing settlement of derivative actions, attorney's fees, and security for expenses?  Stay tuned.  

Update November 8, 2010:  A decision by New York County Commercial Division Justice Eileen Bransten in Cohen PDC, LLC v. Cheslock-Bakker Opportunity Fund, LP, 2010 NY Slip Op 33108(U) (Oct. 18, 2010), collects and adds to the growing list of cases dismissing derivative actions involving LLCs for lack of standing where the claimant no longer holds a membership interest.

Update November 15, 2010:  Read here my post on Justice Bernard Fried's decision in Eldan-Tech, Ltd. v. Ocelot Capital Management, LLC, holding that the majority member of a manager-managed LLC must comply with the demand requirements notwithstanding a vacancy in the manager position.