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.
This arrangement worked for nearly two years until a flood of mortgage refinancings referred by the mortgage company exceeded Gateway's capacity, at which point the mortgage company stopped assigning mortgage closing work to the Attorney. The tensions grew, culminating in a February 17, 2003 meeting of the Brokers and the Attorney at which they orally agreed that Gateway and the Attorney would no longer perform title work for Beverwyck. The Brokers sent the Attorney draft forms for her to execute assigning Gateway's interest in Beverwyck back to the Brokers effective April 1, 2003, but she never signed them. For the balance of 2003, the Brokers continued to operate Beverwyck without Gateway, employing the title services of the same attorney who had been one of Beverwyck's original members before dropping out. In early 2004, the Brokers and this other attorney formed a new company under the name Beverwyck Abstract & Settlement Co., LLC, to perform title work referred by the Brokers' mortgage company.
The Brokers and Gateway ultimately could not reach agreement regarding the winding up of Beverwyck's business. In late 2003, the Brokers commenced a proceeding for judicial dissolution of Beverwyck. The court conducted a two-day bench trial in March 2005, and granted dissolution by order dated May 26, 2005. The court also ordered the parties to prepare final accountings. The two resulting accountings differed by approximately $155,000 based on the use of different accounting periods. The higher number in Gateway's accounting included the entire period following the February 17, 2003 meeting through the formal dissolution on May 26, 2005, whereas the Brokers' accounting stopped March 31, 2003 (the end of the quarter closest in time to the meeting).
The Brokers asked the trial court to determine the date of dissolution for accounting purposes. The Brokers contended that a de facto dissolution occurred at or shortly after the February 17, 2003 meeting by reason of the parties' agreement that Gateway would no longer provide title work for Beverwyck. They argued by analogy to partnership cases in which courts have found from circumstantial proof of the ending of a business relationship the termination of the partnership and concurrent cessation of the partners' fiduciary duties. In a decision dated July 11, 2007 (2007 NY Slip Op 52620[U]), Albany County Commercial Division Justice Richard M. Platkin ruled against the Brokers on the ground that "Beverwyck's operating agreement spells out unequivocally the circumstances under which the LLC will be dissolved," and that there had been no written agreement or vote taken to dissolve the company as the operating agreement required to effectuate voluntary dissolution. As Justice Platkin elaborated:
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Since the members had bound themselves by the terms of their operating agreement, the mere cessation of referrals from [the Broker's mortgage company] to Beverwyck or the bare assertion by [the Brokers] that the company was no longer in existence was insufficient to dissolve the LLC or to relieve [the Brokers] of their fiduciary duties to the organization, since such eventualities were not listed as terminating events in the parties' operating agreement.
The Brokers appealed the decision. Their appellate brief (read it here) pressed the argument for application to LLCs of partnership law principles whereby the partner relation and associated fiduciary duties terminate upon the declared intention of a partner to withdraw from the partnership. They argued that such intention to withdraw was further evidenced by the Attorney's e-mail sent to the Brokers after the February 17, 2003 meeting in which she referred to the parties' "decision to terminate our business relationship" and "our decision to go our separate ways." Gateway's opposing appellate brief (read it here) argued that partnership withdrawal and dissolution rules do not apply to LLCs, and that the trial court correctly applied contract principles in enforcing the provisions of Beverwyck's operating agreement. (My thanks to the attorneys in the case, Robert Ganz and Kevin Luibrand, for providing copies of their briefs.)
The July 17, 2008, decision by the Appellate Division, Third Department, affirmed the lower court's ruling in Gateway's favor, stating:
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We cannot agree with [the Brokers'] heavy reliance upon case law regarding the dissolution of at-will partnerships and joint ventures to support their contention that the parties' fiduciary duties to each other as members of a limited liability company ended when they met and decided on February 17, 2003 that Gateway would no longer provide title insurance services to Beverwyck. The pertinent provisions of the Limited Liability Company Law and Beverwyck's operating agreement provide sufficient guidance here. . . . [I]t is uncontroverted that there was no formal vote or written consent of the majority of the members to dissolve. Inasmuch as they failed to do so, [the Brokers'] argument that they could have unilaterally dissolved Beverwyck because they held a majority interest is unavailing. . . . Absent written consent or formal vote of a majority of the members, the only means of dissolution recognized by the operating agreement and applicable statute was by judicial dissolution.
The court's decision involves only the accounting for Beverwyck. Gateway brought a separate lawsuit against the Brokers and their new title company to recover a share of the latter's profits prior to the judicial dissolution of Beverwyck in May 2005.
The Beverwyck break-up scenario and ensuing litigation tell a cautionary tale of business expediency overtaking legal loose ends in the interregnum between the onset of hostilities and the final dissolution decree. The Brokers must be kicking themselves for not conducting a formal vote and using their 51% majority to dissolve the LLC voluntarily in February 2003. In many instances, however, there is no such easy out, e.g., because there's 50-50 ownership or the operating agreement requires an unattainable super-majority or unanimous consent for a voluntary dissolution. In those situations, short of settlement the best solution is prompt commencement of judicial dissolution and perhaps an interim application for authorization to do business for one's own account under a different company.
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.
The reconciliation was short lived. In May 2007, Whitten re-filed an action for divorce. In late 2007, Madelone and Harrington executed a document formally removing Whitten as manager and notified him of the purchase price and payment terms for the sale of his membership interest. However, Whitten refused to acknowledge either the applicability of the mandatory transfer provisions or that he no longer had a vote on company business, and he continued to hold himself out as the company's manager. Meanwhile, Harrington switched sides, and he, Whitten and the 10% member prepared to remove Madelone as a member and employee of the LLC, which prompted Madelone to commence an action to enforce the transfer provision triggered by Whitten's divorce filing. Madelone's petition alternatively sought to dissolve the LLC on the ground he was frozen out of the company's business. He also alleged that Whitten had taken steps to drive down the LLC's value in connection with his pending matrimonial litigation.
The issue came before Justice Richard M. Platkin of the Albany County Supreme Court, Commercial Division, on Madelone's motion for a preliminary injunction to prevent his removal as a member of the LLC, and to enjoin any company transactions except in the normal course of business. Whitten and the other respondents argued that the parties' conduct demonstrated that the involuntary transfer provisions were not intended to be self-executing, as evidenced by the other members' inaction after Whitten's 2006 divorce filing and for months after his 2007 divorce re-filing. As to the first filing, Justice Platkin agreed with Madelone that any steps taken by the LLC to effectuate the involuntary transfer provisions were rescinded following Whitten's withdrawal of that proceeding. As to the second filing in 2007, Justice Platkin rejected the respondents' waiver argument, pointing to the express non-waiver provision in the operating agreement which required that any waiver be in a signed writing . The judge also rejected respondents' contention that the operating agreement required a member vote to activate the involuntary transfer provision. Lastly, the judge refused to recognize the validity of a resolution "passed" by Harrington and the 10% member at a member meeting in November 2007, purporting to confirm Whitten's member status, stating:
The Court cannot accept respondents' position that the members' action [at the November 2007 meeting] constituted (or could constitute) a waiver, estoppel or de facto amendment of the operating agreement. In addition to the "no-waiver" clause (Section 12.5), the Agreement includes "no-estoppel" and "no-amendment" clauses. . . . In absence of compliance with such provisions, the Court sees no basis for giving force and effect to the November 20, 2007 resolutions (even assuming they were properly adopted). Further, respondents' effort to intentionally estop the company from enforcing the terms of its operating agreement cannot and will not be countenanced by this Court.
Justice Platkin accordingly concluded that Madelone established a likelihood of success with respect to his claim for enforcement of the operating agreement's involuntary transfer provisions. He also found that Madelone would be irreparably harmed by the respondents' plan to terminate his employment and membership interest, and therefore granted the requested preliminary injunction against the LLC acting by and through the respondents.
Query: Assuming Madelone ultimately obtains a judgment granting specific enforcement of the involuntary transfer by Whitten, what is the remedy if the two respondents other than Whitten either can't or won't purchase their pro rata share of Whitten's membership interest? Perhaps the operating agreement provides that Madelone has the right to acquire those shares as well. If not, the more pressing issue may become, can the LLC remain a viable business pending such uncertainties concerning its ownership?
Court Grants Specific Performance of LLC Members' Buy-Sell Agreement
On its surface, the case of Berle v. Buckley discussed below is about routine contract law, the question being whether an exchange of letters between two parties constituted a binding agreement or merely an unenforceable expression of intent. What makes it compelling reading is its wrenching setting -- the breakup of a family as well as a business -- and the undeniable, unpredictable human element at play as the two parties, one with a lawyer and the other without, made important decisions with known or unknown legal consequences in a tightly compressed time frame.
The Facts:
Beatrice Berle and Abdon Buckley never married, but for 13 years they lived and worked together on a 500-acre farm in upstate New York, producing organic goat cheese, straw and hay. They also produced two children. At some point, things went wrong for Berle and Buckley, very wrong. Berle accused Buckley of physical, sexual, verbal and mental abuse. In 2007, Berle petitioned the court for sole custody of the children and obtained a protective order banning Buckley from entering the farm property.
The farm business was owned through a limited liability company called Berle Farm, LLC, of which Berle held a two-thirds membership interest and Buckley held the other third. Wishing to sever her business ties with Buckley, Berle forwarded to him a letter addressed to her from her own lawyer, dated September 10, 2007 (the "September 10 Offer"), outlining how Buckley's interest could be purchased by Berle as well as the procedures for judicial dissolution of the LLC if Buckley refused to sell. The September 10 Offer proposed to purchase Buckley's interest for $268,666 based on the appraised value of the farm plus the fair market value of the LLC's assets and other equipment, net of a loan balance due Berle. It also proposed a lump sum payment subject to specified terms and conditions including a requirement that Buckley not enter into any farming operation or reside within 20 miles of the farm.
Buckley didn't have a lawyer. On September 12, 2007, Buckley and Berle's lawyer had a telephone conversation which the lawyer then confirmed in a letter sent by fax the same day to Buckley, advising him to retain counsel; confirming Buckley's agreement to the terms of the September 10 Offer except that Buckley wanted to farm and/or reside on family property in Cambridge, NY; advising Buckley that his latter proposal was acceptable if all other terms of Berle's offer were acceptable to Buckley; and informing Buckley that the purchase price needed to be adjusted to reflect Buckley's removal of "several thousand dollars of cash from the safe located at the Berle Farm property". The letter closes by requesting Buckley to "signify his consent to the foregoing terms by signing this letter in the space below" and returning it before the close of business on September 13, 2007, and that, otherwise, Berle will "commence legal proceedings for the dissolution of Berle Farm, LLC".
Buckley did not countersign the letter. Instead, on September 13, 2007, Buckley prepared and sent Berle's lawyer a form of agreement (the "Buy-Sell Agreement") bearing Buckley's notarized signature. The Buy-Sell Agreement reiterated much of the September 10 Offer including the purchase price and timing of the payment. It also reflected certain modifications including Buckley's agreement to reduce the purchase price by $1,100 for the cash he removed from the safe, and a proviso allowing him to farm and/or reside on his family property. The Buy-Sell Agreement closed by stating that Buckley "believes this agreement is a faithful representation of all matters formerly addressed, and affixes his signature below to affirm his acceptance of this agreement". Buckley's cover letter to Berle's lawyer stated:
In an attempt to meet the deadline specified by your office in your fax of September 12, 2007, I am preparing an agreement to sign and fax. This agreement I believe will meet your original specifications, with the inclusion of the additional information addressed in the faxes. They are indicated by [numbered] notes on page 3 of this agreement. I appreciate your reiterated advice to acquire legal representation, and have been working towards that end, but have been unsuccessful within the stated time constraints.
After receiving the Buy-Sell Agreement, on September 14, 2007, Berle's lawyer wrote to Buckley as follows:
I have received your memorandum of September 12 and your letter of yesterday and since it appears that, subject to confirming with Ms. Berle the amount of cash taken from the Berle Farm safe, there is general agreement regarding the terms of the purchase of your interest in Berle Farms, LLC, we are turning our attention to the drafting of a formal agreement which will contain the typical provisions regarding the purchase as well as the specific provisions that have been addressed in our communications. I expect that I will be able to send you the draft agreement for review next week. It would certainly be beneficial for you to retain counsel to review the contract.
Berle's lawyer subsequently prepared and sent to Buckley a proposed final Membership Interest Purchase Agreement ("MIPA"). At this point, Buckley retained a lawyer to review the MIPA. The lawyer advised Buckley not to sign the MIPA without further modifications which the lawyer then tried to negotiate with Berle's lawyer. The negotiations proved unsuccessful.
The Claims:
On December 7, 2007, Berle petitioned the Supreme Court, Rensselaer County, for an order granting her specific performance of the Buy-Sell Agreement and compelling Buckley to transfer his one-third membership interest in the LLC. Alternatively, Berle sought an order dissolving the LLC pursuant to Section 702 of the LLC Law. Buckley cross-petitioned for an order of dissolution, the appointment of a liquidating receiver and an accounting.
Buckley contended that Berle's claims of abuse were fabricated as part of an effort to force him out of the LLC. Berle countered with a non-party affidavit stating that she witnessed the bruising on Berle's body resulting from Buckley's abuse. Buckley argued that he never intended the Buy-Sell Agreement to be a final and complete contract; that he merely expressed his interest in Berle's proposal and his willingness to engage in continued negotiations relative to her buyout offer; that he did not have sufficient time to consult with an attorney prior to Berle's deadline; and that he did not understand how the threatened judicial dissolution of the LLC would affect his interest. Berle argued that the Buy-Sell Agreement constituted a binding acceptance of her offers embodied in her attorney's September 10 Offer and September 12 letter.
The Decision:
The task fell to Supreme Court Justice Richard M. Platkin to determine whether the parties' dealings coalesced into a binding agreement, or were simply a non-binding agreement to agree. Read his decision here.
His legal analysis begins with a summary of the governing principles. First, the existence of a binding contract does not turn on the parties' subjective intent but, rather, on the objective manifestations of the parties' intent as expressed in their words and deeds which are to be viewed in their totality. Second, where it is clear that parties intended to bind themselves to future performance, the fact that some terms may be left open does not necessarily render the agreement unenforceable.
Applying these principles, Justice Platkin concludes that Buckley entered into a binding contract to sell his one-third membership interest in the LLC to Berle for $267,566, subject to the other terms in the Buy-Sell Agreement. Justice Platkin notes that Buckley did not dispute that the September 10 Offer and September 12 letter from Berle's lawyer constituted a valid offer. Justice Platkin then addresses as follows the decisive issue, whether Buckley's Buy-Sell Agreement constitutes an acceptance of Berle's offer:
The issue then becomes whether defendant's transmittal of the Buy-Sell Agreement to plaintiff's counsel constituted an acceptance of the offer. The Court concludes that it does. The Buy-Sell Agreement, signed by defendant in the presence of a notary, recites the essential terms of the transaction, including the amount to be paid to defendant for his one-third membership interest and the timing of such payment. It also addresses the two minor issues left outstanding following transmittal of the September 12 letter: (1) the precise amount by which the purchase price must be reduced to reflect defendant's removal of cash from the LLC's safe; and (2) the exact location of the family property upon which defendant seeks to farm and/or reside. Indeed, the Buy-Sell Agreement prepared by defendant contains an express acknowledgment that it represents a written memorialization of the parties' meeting of the minds: defendant acknowledges that such "agreement is a faithful representation of all matters formerly addressed, and affixes his signature below to affirm his acceptance of this agreement."
Buckley, the judge further comments, "prepared and transmitted the Buy-Sell Agreement to accept [Berle's] buy-out proposal prior to the deadline for the purpose of avoiding litigation". As to the September 14 letter from Berle's lawyer, advising Buckley that he would be sending him a formal agreement and recommending that Buckley engage counsel to review it, Justice Platkin finds no inconsistency with the existence of a binding agreement. Here's what he wrote:
The fact that the parties' written agreement on the essential terms of the buy-out transaction were subject to the preparation of a definitive "formal agreement" that would include "typical provisions" regarding the purchase of an LLC membership interest (in addition to the specific terms negotiated by defendant and plaintiff's counsel) did not "leave the transaction incomplete and without binding force in the absence of a positive agreement that it should not be binding until so reduced to writing and formally executed" (Municipal Consultants & Publs., Inc. v. Town of Ramapo, 47 NY2d 144, 149 [1979]).
This last point perhaps is the most important take-away from this case for anyone involved in contract negotiations, be they lawyer or layperson. If you want to ensure that the writings being exchanged are a non-binding expression of intent, then say so. All it takes is one sentence at the bottom of the term sheet or in a cover letter, something like, "It is understood that this is not a binding agreement and that the obligations and rights of the parties shall be set forth in the definitive agreement to be executed by the parties". In this case, it seemed pretty clear that Buckley took seriously and therefore sought to allay Berle's lawyer's threat of a dissolution proceeding by giving him written assurance that he intended to be bound by his agreement. By then, it was too late to bring in counsel to re-negotiate the deal.
The Aftermath:
Subsequent proceedings in Berle also offer a little something for civil procedure buffs. Buckley filed a notice of appeal from the order which required him formally to transfer his membership interest to Berle within 30 days. In an attempt to stay enforcement of the lower court's order pending his appeal, Buckley filed with the County Clerk a Bill of Sale and Assignment of his membership interest along with an Affidavit of Lost Membership Certificate. Buckley then refused to proceed with the transfer, asserting that the filings entitled him to an automatic stay of enforcement under Section 5519(a)(5) of the Civil Procedure Law and Rules (CPLR). Under that provision, the lower court's order automatically is stayed upon filing a notice of appeal where "the judgment or order directs the execution of any instrument, and the instrument is executed and deposited in the office where the original judgment or order is entered to abide the direction of the court to which the appeal is taken". Berle disagreed and asked the court to hold Buckley in contempt of court.
Justice Platkin didn't hold Buckley in contempt, but he also didn't agree that Buckley was entitled to an automatic stay, and he gave him an additional two weeks to transfer his interest (read decision here). The judge held that subsection (a)(4) of CPLR 5519 also applies, and that Buckley had not complied with it. The automatic stay under (a)(4) applies where "the judgment or order directs the assignment or delivery of personal property and the property is placed in the custody of an officer designated by the court of original instance to abide the direction of the court to which the appeal is taken . . .." In this case, ruled Justice Platkin, Buckley's membership interest constitutes personal property (see Section 601 of the LLC Law), and the court's order "implicitly required the parties to execute a written instrument binding them to the negotiated terms and conditions of the Buy-Sell Agreement, to which such transfer was subject". Buckley's bare Bill of Sale and Assignment did not do the trick.
UPDATE (12/29/08): Buckley appealed the order granting specific performance. In a decision dated December 24, 2008, the Appellate Division, Third Department, reversed the lower court's order on the purely procedural ground that the lower court had acted prematurely in making a summary determination of the issue. Although the lower court could have made a summary determination regarding dissolution, the claim for specific performance was not part of the dissolution relief. The case therefore goes back down to the lower court for further proceedings.
