Winning the Dissolution Battle, Losing the War
Most business divorce litigation involving closely held companies results either in a buyout of one party by the other, or the two sides dividing the remaining assets and going their separate ways.
The biggest problem getting to the buyout is the absence of a public market to establish the value of the interest being acquired, particularly when dealing with a non-controlling interest in a sales or services-based operating company. The buyer and seller, even when advised by qualified business appraisers, can be light years apart on price due to different assumptions about a host of valuation inputs some of which necessarily require subjective analysis.
Splitting up the business can be very easy or very difficult, depending on the specifics of the business. It tends to be more difficult when there is value associated with the defunct company's name or other such intangible good will value at the enterprise level (as opposed to personal good will that follows the individual business partner wherever he or she goes).
Litigation means time, expense and uncertainty, all of which can jeopardize the potential benefits of an eventual buyout or business split-up. It is difficult for the controlling owner to invest and make business plans while under the cloud of a prospective buyout of uncertain magnitude. The risks can be even greater in a split-up scenario for business partners who, perhaps as a matter of business survival, begin taking unilateral and sometimes surreptitious steps at odds with each other, designed to retain for themselves the loyalty and business of key customers and vendors.
These ruminations, and the title of this post, are inspired by recent decisions in two cases in which business partners remain locked in protracted and undoubtedly expensive litigation even after one side's initial attempt to achieve judicial dissolution became moot.
The first decision is Mouhlas Realty, LLC v. Koutelos, 2009 NY Slip Op 30893(U) (Sup Ct Queens County Apr. 7, 2009). If the party names sound familiar, that's because I highlighted a prior decision in this LLC dissolution case in a post last year (read here). In the prior decision, Queens County Supreme Court Justice Patricia Satterfield held that the petitioner, who owned a minority membership interest in the LLC, failed to establish grounds for judicial dissolution under LLC Law Section 702, and also held that the controlling members had no right to compel an "equitable" buyout of the petitioner's interest -- thereby leaving the litigants locked in a relationship neither wants. The decision also left unresolved a series of counterclaims brought by the controlling members against the petitioner, including one seeking imposition of a judicial lien on her membership interest on account of an unsatisfied demand for capital contribution.
Justice Satterfield's recent decision addresses the controlling members' motion for summary judgment on those unresolved claims. The controlling members argued, based on the "law of the case" doctrine, that the court's prior rejection of the minority member's grounds for dissolution, including her objection to a mandatory capital contribution, entitled them to judgment against her for specific performance enforcing the capital contribution requirement and imposing a lien. Justice Satterfield disagreed, stating that her prior decision did not determine the propriety of the capital call, only that there was no statutory prohibition against it, and that the petitioner failed to show that the LLC is unable to function in accordance with its operating agreement or that the business is failing financially.
So here it is, over a year after the minority member sued for dissolution, and even though the issue of dissolution has been taken out of the case, the parties seemingly are not one step closer to resolving their broken relationship. Have the parties been discussing a buyout? I don't know, I can only assume that they have and, if so, that the demand and offer are too far apart due to different views of the business value and/or the impact on price of the capital call.
The second case is Stack v. O'Higgins, 2009 NY Slip Op 30874(U) (Sup Ct NY County Apr. 2, 2009), decided by the newest member of the Commercial Division of the New York County Supreme Court, Justice Shirley Werner Kornreich. The plaintiff, Lawrence Stack, and the defendant, Michael O'Higgins, are 50-50 members of an LLC called Stack's Sales East Coast LLC ("SSEC") which buys and sells rare coins, medals, paper currency and other numismatic items. In September 2006, Stack brought an action for judicial dissolution of SSEC due to disagreement regarding the proposed transfer of Stack's membership interest. It appears from the court's docket that the case got bogged down in discovery for the next year and a half. Again, I don't know if any buyout negotiations took place in the interim.
What we do know from the court's decision is that in May 2008, Stack changed course by sending O'Higgins a written notice purporting to exercise his right under the operating agreement to cancel SSEC's license to use the word "Stack" in its company name or otherwise. The relevant section of the operating agreement expressly conditioned the license termination on Stack's withdrawal from SSEC or SSEC's dissolution, so O'Higgins responded with a letter demanding confirmation of Stack's withdrawal, which Stack gave by written notice in September 2008. Soon thereafter, O'Higgins filed a certificate of amendment changing SSEC's name to "Steib's Sales East Coast LLC."
Did Stack's withdrawal from SSEC, which effectively mooted his claim for dissolution, end the hostilities? Not by a long shot. Even after the formal withdrawal, O'Higgins apparently continued to use Stack's name to market and advertise his business, as evidenced by certain trade journal ads and online directories. This prompted Stack to file a motion to amend his complaint to add claims for breach of contract, a declaratory judgment and a permanent injunction. O'Higgins opposed the motion on the grounds that Stack's withdrawal from SSEC mooted the entire action and that, in any event, his company's official change of name met any obligation under the operating agreement to cease using Stack's name. Justice Kornreich rejected O'Higgins' contentions and, for the most part, granted Stack leave to amend his complaint.
Stack, as Stack's Rare Coins, and O'Higgins, as Steib's Sales East Coast, are now business competitors fighting each other for customers, sources and for the good will they spent years developing jointly. Dissolution is out of the picture. Yet they are still locked in a three-year old litigation that drains their financial resources, places in the public record matters that most business owners prefer to keep private, and distracts from time better spent building their business.
In both of these cases, Koutelos and Stack, the defendants avoided dissolution and were able to carry onward in control of the business. In that narrow sense they won the dissolution battle. But in both cases the war goes on to an uncertain end as they continue to litigate their unresolved business and financial differences.
Judicial Dissolution of the Unprofitable LLC
This is a tale of two cases, decided five years apart, involving my all-time favorite business divorce topic: judicial dissolution of the limited liability company (LLC). The cases raise the interesting question whether a member may seek dissolution on the ground that the LLC is not profitable.
First, a bit of background for the uninitiated. The LLC is an unincorporated business entity that combines the limited liability benefits of the corporation with the favorable pass-through tax treatment of partnerships. Compared to the highly structured, mandatory provisions of the business corporation laws, the LLC laws offer far more flexibility and freedom of contract among the LLC members to order their ownership, economic and managerial relations as they see fit. LLCs are fast on the way to becoming the preferred form of closely held business organization. Already, in a number of states including Delaware, new LLC filings outnumber new corporation filings.
The New York LLC Law's sparsely worded provision for judicial dissolution, codified in Section 702 of the LLC Law, borrowed its language from the limited partnership law. Section 702 provides in relevant part:
On application by or for a member, the supreme court in the judicial district in which the office of the limited liability company is located may decree dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement.
The articles of organization generally parrot the minimal informational requirements set forth in LLC Law Section 203(e). Dissolution under Section 702 therefore is all about whether the member who seeks to dissolve the LLC can demonstrate that its business is not functioning as called for by the terms of the operating agreement. This is a narrower standard than that found in Sections 1104 and 1104-a of the Business Corporation Law governing closely held corporations. (For readers who'd like to learn more about the background of Section 702 and its treatment in the early case law, grab a hold of my June 2002 article published in the New York State Bar Association Journal, entitled "When Limited Liability Companies Seek Judicial Dissolution, Will the Statute Be Up to the Task?")
Now lets turn to the two cases, the first of which was decided in 2003 and is entitled Schindler v. Niche Media Holdings, LLC (read decision here). The case was brought by a one-third member of an LLC that owned and published magazines. The plaintiff, Schindler, accused the company's CEO, who held a 35.7% interest, of misappropriating company assets and wrongfully terminating Schindler's employment. The complaint included a claim to dissolve the LLC under Section 702 on the ground that liquidation was the only feasible means for the members to obtain a fair return on their investment.
Schindler moved to preliminarily enjoin the CEO from using LLC funds to pay his legal fees in defense of the action. New York County Supreme Court Justice Shirley Werner Kornreich denied the motion on the ground, among others, that Schindler had no likelihood of success on the merits of his underlying dissolution claim. Schindler, according to the judge, admitted the LLC's magazine business was flourishing and offered no evidence that the LLC was unable to carry on its business in accordance with the articles of organization or operating agreement. In so ruling, the judge construed Section 702 as follows:
While this standard has never been construed in the case law, the Court interprets it to mean that judicial dissolution will be ordered only where the complaining member can show that the business sought to be dissolved is unable to function as intended, or else that it is failing financially. [Italics added.]
I have no quarrel with the first part of the judge's statement, but the second part -- "or else that it is failing financially" -- struck me when I first read it as judicial fiat. There's nothing in Section 702 that even hints at financial failure as an independent basis for dissolution. The decision cites no case precedent for the proposition, which appears to be pure dicta in any event. Nor does the judge cite any statutory or case authority under the Business Corporation Law. On the contrary, BCL Section 1111(b)(3) says that dissolution should not be denied "merely because it is found that the corporate business has been or could be conducted at a profit." Profitability or the lack thereof, by itself, clearly is no basis to grant or deny dissolution, assuming the operating agreement itself does not set forth some measure of financial distress as ground for dissolution.
In subsequent years I have seen the Schindler formulation quoted on numerous occasions in published and unpublished decisions. In none of the cases, however, did the court grant or deny dissolution on the sole basis that the LLC was or wasn't operating profitably.
That is, none until last month, in a case called Matter of Youngwall (Youngwall Realty, LLC) decided by Nassau County Supreme Court Justice Stephen A. Bucaria (read decision here). The LLC involved in Youngwall had two members, brothers Nils (the one seeking dissolution) and Perry, and a non-member manager named Megale who allegedly was aligned with Perry. The decision does not specify the membership percentage interests held by the brothers. The LLC owned a commercial building profitably leased for many years to a company named Transaero Inc. that had been 80% owned by the members' father until his death in 2006. The father's bequest of all of his Transaero shares to Perry was being challenged by Nils in surrogate's court. Meanwhile, in September 2007 Transaero's lease expired and it vacated the property in November 2007. The next month Nils filed for dissolution, alleging that Perry rejected his requests to cause the LLC either to sell the now-vacant property or to find a new tenant, that without a rent-paying tenant the building had become a liability, and that the animosity between the two brothers made it impossible for them to confer or cooperate to carry on the LLC's business. Perry countered that there was no risk to the assets of the LLC which continued to operate under Megale's management who was pursuing its best interests.
Justice Bucaria begins his analysis by distinguishing the grounds for dissolution under LLC Law Section 702 from those governing closed corporations under BCL Sections 1104 and 1104-a. He aptly characterizes Section 702 as "more general, while being more specific" in its tie-in to the operating agreement. He then notes the provision in the parties' operating agreement stating that the LLC "is formed for any lawful business purpose," and observes that the term "business" is defined in LLC Law Section 102(e) as meaning "every trade, occupation, profession or commercial activity." He next refers to the Practice Commentary to the LLC Law in which the commentator states that "the drafters intended that LLCs form for pecuniary profit". He also cites the statement in Perry's affidavit that the LLC "can continue to operate and make further profit for its members," leading him to find that the "plain and ordinary content and intent of the parties and the Operating Agreement of the LLC was, and is, to make a profit for the members, Perry Youngwall and Nils Youngwall." Dissolution is warranted, Justice Bucaria concludes, because the LLC is no longer a profit-making entity. Here's the key passage from the decision:
The Court is cognizant of the past history of the LLC and its profit stream, and the uninterrupted income provided by the LLC . . . to the litigants/members herein. While instructive, it is not decisive of LLCL 702. The statute, as written, that a dissolution may be decreed when ". . . it is not reasonably practicable to carry on the [profitability] . . ." That language clearly contemplates the future of the LLC, i.e., after November 30, 2007 (when Transaero vacated the premises). Transaero was the only tenant, and there is no dispute that the LLC is not a profit-making entity at this time. Nor is there any admissible documentary proof that either the manager or the members are actively pursuing a future/current replacement for Transaero, notwithstanding the self-serving statements of the respondent and the manager, whose motives are questionable, given the concurrent litigation in Surrogate Court and the latter's employment. . . .
. . . Due to the intense personal animosity between the members, the lack of any proof of the current profitability of the LLC, the apparent inability ". . . to function as intended . . ." (Schindler v. Niche Media Holdings, LLC, 1 Misc3d 713, 772 NYS2d 781, 785, C.CT., NY County 2003), dissolution is appropriate. [Emphases in original.]
Note the citation to Schindler whose questionable dicta has now become the basis for dissolving the LLC in Youngwall, though in quoting from Schindler Justice Bucaria omits the phrase, "or else that it is failing financially."
I've got a bunch of questions, beginning with, what inconsistency is there between the express terms of the operating agreement in Youngwall and the fact that the building's current vacancy is causing a cash drain? If every LLC is formed for pecuniary profit (this seems self evident), is every LLC that fails to make a profit for any given period prone to judicial dissolution at any member's request? What motive would Perry have to keep vacant a valuable commercial property in which he has at least as much a beneficial interest as his brother? How much equity does the LLC have in the property? Is the property listed with brokers for sale or lease? Is it all that unusual for a one-tenant commercial property to experience vacancy for some months between tenants? Does the LLC have adequate cash reserves to weather a period of vacancy?
Also note the court's reliance on the brothers' personal animosity even though the operating agreement vests management of the LLC exclusively in Megale. Should it make a difference that Megale appears to be on Perry's side? Are Nils' grievances better suited for a derivative action asserting claims against Perry and Megale for breach of fiduciary duty for keeping the property off the market against the LLC's best interests?
Youngwall would be an easier, more compelling case for dissolution if it was a member-managed LLC with the two brothers in a 50-50 deadlock over the disposition of the property. I can only speculate that the deceased father foresaw fraternal strife and for that reason set up the LLC with a third-party manager.
The biggest question raised by Schindler and Youngwall is whether courts should ever consider dissolving an LLC solely on the ground of its unprofitability in the absence of some express provision in the operating agreement that creates the nonconformity required by Section 702. Here's how the argument against might go: Responsibility for LLC finances, business planning and profitability is vested in the managers of the LLC. Courts routinely defer to determinations by a corporation's board of directors on such matters under the business judgment rule. It should be no different for LLC managers. There are untold numbers of companies, public and private, that run in the red for periods of time before they either turn around or file for bankruptcy. Opening up LLCs for dissolution on the ground of unprofitability takes courts where they should not go and creates yet another, undesirable dissonance with the law governing dissolution of business corporations.
I suspect it will be far less than another five years before the next case raising this issue comes along. Stay tuned.
