Court Orders Dissolution of Unprofitable Real Estate LLC
Back in 2008, I wrote a couple of posts about the Youngwall case in which the court ordered involuntary dissolution of a commercial real estate limited liability company (LLC) owned 50/50 by two brothers who also were involved in a bitter dispute over their father's will, based on the personal animosity between the brothers and because the vacant building was losing money (read here and here).
Youngwall foreshadowed the landmark decision in 2010 by the Appellate Division, Second Department, in the 1545 Ocean Avenue case, which redefined the standard for judicial dissolution of LLCs under §702 of the LLC Law as requiring the petitioner to show "in the context of the terms of the operating agreement or articles of incorporation, that (1) the management of the entity is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved, or (2) continuing the entity is financially unfeasible."
I emphasize the disjunctive "or" in the quoted passage because the cases involving judicial dissolution petitions based solely on financially failing LLCs are few and far between, as opposed to the more common scenarios involving management and/or money disputes between members of otherwise profitable ventures. The explanation may well be that most business people don't like to pay lawyer's fees fighting over a corpse.
LLCs being the entity of choice for real estate holding companies, and the real estate market having remained in a slump the last four years, it was only a matter of time before another Youngwall case appeared. And so it has, in the form of Mizrahi v. Cohen, 2012 NY Slip Op 50030(U) (Sup Ct Kings County Jan. 12, 2012), decided last week by Brooklyn Commercial Division Justice Carolyn E. Demarest.
Mizrahi, like Youngwall, is a family feud between brothers-in-law -- one a dentist, the other an optometrist -- who in 1999 purchased a property in Brooklyn's Gravesend section and subsequently built a mixed-use building to house their own businesses and to rent to other tenants. They formed an LLC named 372-376 Avenue U Realty, LLC to own the property and entered into a written Operating Agreement as 50/50 managing members.
The LLC obtained mortgage financing, personally guaranteed by both members, for the purchase of the realty and construction of the four-story building which wasn't completed and occupied until 2006 when the original mortgage was refinanced in the sum of $4.7 million. The plaintiff dentist, Mizrahi, occupied a second floor office and the defendant optometrist, Cohen, occupied a smaller ground floor unit.
At the outset the two members contributed $100,000 each. The Operating Agreement required no additional capital contribution absent the members' unanimous consent. The Operating Agreement also generally provided for unanimous approval of "any matter coming before the Members."
Until 2003, the two members made additional capital contributions in equal shares to cover expenses. After 2003, Mizrahi made substantial, unmatched contributions and loans to the LLC. By the time of trial in 2011, Mizrahi's capital contributions totaled almost $1.2 million compared to about $300,000 for Cohen.
In 2010, Mizrahi filed a complaint seeking judicial dissolution of the LLC and asserting claims against Cohen for an accounting and damages for alleged embezzlement of LLC funds and failure to make his share of capital contributions.
Justice Demarest's analysis of the dissolution claim begins by citing 1545 Ocean Avenue and other cases for the proposition that "the court must look to the Operating Agreement to determine the rules applicable to the operation of a particular LLC" and that "[o]nly where the Operating Agreement is ambiguous, contrary to law or does not contain any provision for the particular matter at issue, do the statutory provisions of the [LLC Law] control."
Mizrahi centered his dissolution claim on Cohen's alleged failure to carry his "fair share" of the financial responsibility for the real estate business under the terms of the Operating Agreement. He also claimed, and Justice Demarest agreed, that Cohen breached fiduciary duty by withdrawing $230,000 that the LLC could ill afford as a loan to himself, after Mizrahi withheld his consent.
Cohen argued that the dissolution claim should be dismissed because the Operating Agreement limits the conditions under which the LLC can be dissolved to the members' unanimous consent or certain defined events of "involuntary withdrawal" by a member which were not present. Justice Demarest labeled the argument "specious," stating:
Such interpretation of the law would void the statutory provision for judicial dissolution pursuant to Section 702 of the LLCL in any situation in which an operating agreement provided for dissolution only on consent or at the end of a definite term of duration for the LLC, and would thus thwart the obvious legislative intent of LLCL §702, to provide a mechanism to equitably terminate a business relationship that is dysfunctional or abusive, without the consent of all of the members.
Justice Demarest instead posed the central question in the case as
whether plaintiff has borne his burden to demonstrate that it is impracticable to continue the operation of the LLC in light of Cohen's failure to provide needed financial support and his undermining of the LLC's financial integrity so as to warrant dissolution of the LLC.
The answer came largely from the LLC's accountant, who testified that the LLC consistently operated at annual losses totaling over $1.1 million in the years 2006 (when the building was first occupied) through the trial in 2011, which loss was covered by application of mortgage proceeds to the day-to-day operations of the LLC and by Mizrahi's capital contributions which prevented foreclosure on the property. Justice Demarest also credited the accountant's testimony that the monthly carrying charges for mortgage, taxes and building expenses totaling over $51,000 exceeded the rent roll by about $12,000 per month. Cohen's contention that the LLC "going forward" will show a profit, Justice Demarest commented, "appears to be based on speculation and wishful thinking."
Justice Demarest concluded that "given the significant losses sustained over the years, which were covered by plaintiff, it is not plausible that continuing the LLC, as presently constituted, is feasible." Under the Operating Agreement's terms, the plaintiff Mizrahi is under no obligation to continue making capital contributions to keep the LLC afloat. Justice Demarest's fuller explanation is worth reading:
In 1545 Ocean, the Appellate Court cautioned that "[d]issolution is a drastic remedy", not to be lightly ordered merely based upon disagreement, or even deadlock, among the members of the LLC, but that "where the economic purpose of the limited liability company is not met, dissolution is appropriate"(72 AD3d at 129-131). In the case here, the agreed purpose of the LLC is the development and management of a mixed-use building, presumably for the economic benefit of its members. That purpose was achieved by the construction and occupancy of the building, but the expected profit has not been realized and the building does not support the costs of its maintenance, including payment of the mortgage taken to finance the project. The deficit has consistently been financed unilaterally by plaintiff, who, under the terms of the Operating Agreement, cannot be liable for the debts of the LLC (Section 3.2). Defendant not only has failed to contribute equally in meeting the losses, but has affirmatively undermined the financial integrity of the LLC by withdrawing a substantial portion of his capital contributions, thus evidencing his inability or unwillingness to permit or promote the purpose of the LLC. Under these circumstances, it is only a matter of time, should plaintiff choose to exercise his right to refrain from making additional capital contributions or loans to the LLC, before the LLC will default upon its mortgage and the mortgage will be foreclosed, thus eliminating the sole purpose of the LLC. Accordingly, plaintiff has established that continuing the LLC is financially unfeasible and that the LLC should be dissolved. (See Mehraban v McIntosh, 2011 WL 486101, p.3 [Sup St, Nassau Co., 2011]).
The plaintiff also contended that, upon dissolution, he should be allocated a greater than 50% interest in the LLC proportional to his capital contributions and should be permitted to purchase Cohen's diminished interest. The plaintiff relied on Matter of Superior Vending, about which I wrote here, where the court ordered an equitable "liquidation" by means of requiring one member of the LLC to pay the other an amount equal to his investment in the LLC plus interest. Justice Demarest didn't buy it, distinguishing the two cases as follows:
Superior Vending involved a limited liability company formed to acquire and operate a vending machine company. The business had been originated by one of the members through his own corporation and was expanded to a second company through investments made by the other member three years later. No operating agreement was ever executed and the relationship of the LLC members terminated after two years, but the LLC continued to operate under the management of the original member. An initial effort to dissolve Superior Vending was abandoned by the departing member, but a new petition was brought three years later to recover his share of the assets and interim distributions. Unlike the case here, the members consented to dissolution and had severed their mutual operation of the business years prior to the litigation. Because one member had continued to operate, and had expanded, the business in the intervening years, the court found it appropriate, after determining the departing member's right to recovery on his investment, to permit the remaining member to purchase, or buy-out, the other member's interest for that sum, notwithstanding the absence of a provision for such relief in the LLCL. As is apparent from the stated facts of that case, the equities of the Superior Vending case differ from the circumstances at bar in which both members have remained active in the operation of the LLC and there has been no hiatus in their joint participation, other than that created by plaintiff's removal of the bank account from access by defendant.
The Mizrahi opinion, besides ordering dissolution and appointing the company accountant to perform an accounting, addresses a number of other interesting factual and legal issues, so do yourself a favor and read it in its entirety.
Judges Thinking Outside the LLC Dissolution Box
The title of this week's post is inspired by two recent decisions in LLC dissolution cases in which courts crafted remedial measures that appear to venture into new territory in an effort to achieve efficient and equitable resolution of the parties' dispute.
In one case, the court ordered an appraisal proceeding for a buyout of the petitioning member's interest after denying his request to dissolve the LLC. In the other, involving a dispute between 50/50 managing members, the court appointed a temporary receiver with limited powers to monitor the LLC's financial activity.
The appraisal remedy was ordered by Commercial Division Justice Stephen A. Bucaria in Matter of Gold (Cosmo Holdings LLC), Short Form Order, Index No. 6722/11 (Sup Ct Nassau County Oct. 26, 2011). The petitioner in Gold is a 25% member and the respondent Kanter is a 75% member of a member managed LLC called Cosmo Holdings LLC formed in 2007 to invest in other companies. Each member made an initial capital contribution over one-half million dollars. The operating agreement provides that a member who wishes to sell his or her interest must first make an offer to the other member to sell at a mutually agreed upon price.
In 2009, Kanter removed Gold as a signatory on Cosmo's bank account. In May 2011, Gold petitioned to dissolve Cosmo based upon deadlock between the managing members. Gold also alleged that Kanter withheld financial information and refused to make distributions to Gold.
Justice Bucaria's decision first summarizes the standard for judicial dissolution of LLCs under §702 of the LLC Law, as construed by the Appellate Division, Second Department, in the 1545 Ocean Avenue case:
[LLC Law] §702 provides that a court may decree judicial 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 the operating agreement. Dissolution is a drastic remedy, which is not to be granted unless management is unwilling or unable to promote the company's stated purpose or continuing the company is financially unfeasible.
Justice Bucaria then turns to Cosmo's operating agreement, which in critical part provides that members holding a majority of the capital interests shall elect the managers. "As the holder of a majority membership interest," Justice Bucaria writes, "respondent [Kanter] has the authority to exclude petitioner [Gold] from the management of Cosmo." He then finds that Gold has not established that Kanter as managing member "is unable or unwilling to promote Cosmo's purpose of investment" and has not shown that "the continuation of Cosmo is financially unfeasible." Justice Bucaria accordingly denies Gold's application for judicial dissolution.
Does Gold go home empty handed, relegated to a passive-investor role for the life of the LLC? Not quite. Justice Bucaria's decision orders a buyout appraisal of Gold's membership interest in the LLC, stating as follows:
However, absent agreement between the parties as to buyout price, petitioner has the common law right to an appraisal proceeding for the purpose of determining the fair market value of her membership interest in the limited liability company (Appleton Acquisition, LLC v. National Housing Partnership, 10 NY3d 250, 256 [2008]). The parties shall conduct discovery as to the fair market value of petitioner's interest in Cosmo Holdings as of the date of the filing of the dissolution petition, May 5, 2011.
In the cited Appleton case, New York's highest court held that under the Revised Limited Partnership Law, a limited partner could not bring a plenary action under common law to seek rescission of a merger and, instead, was restricted to his or her statutory appraisal remedy.
Other New York courts have enforced an equitable buyout of an LLC membership, albeit under special circumstances where the courts characterized the relief as a species of "liquidation" based on a finding of grounds for dissolution, such as in Lyons v. Salamone, 32 AD3d 757 (1st Dept 2006), and Matter of Superior Vending, LLC, 71 AD3d 1153 (2d Dept 2010). As far as I know, the decision in Gold is the first instance in which a court granted a straight buyout remedy for an LLC member without there being a basis for dissolution. It will be interesting to see if other courts follow Gold's lead.
The second case, involving a less momentous but still novel remedy in an LLC dissolution proceeding, is Scomello v. Pascarella, 2011 NY Slip Op 51965(U) (Sup Ct Suffolk County Nov. 2, 2011). The LLC in Scomello operates a non-medical clinic offering various skin care and "appearance enhancement" treatments. The plaintiff and defendant, each owning a 50% interest in the member-managed LLC, filed suit and counter-suit accusing each other of various financial and management irregularities. The defendant's counter-suit included a claim for dissolution under LLC Law §702 and a request for appointment of a temporary receiver to manage the business pending the litigation. Both parties also moved for preliminary injunctive relief of various sorts.
The decision by Commercial Division Justice Emily Pines comments that the two members present "diametrically opposed allegations of what has occurred in their business relationship," and that "the continued operation of the LLC may depend on an equitable accounting in accordance with the [Operating] Agreement's provisions." To maintain the status quo and preserve the LLC's assets, Justice Pines permits the plaintiff member to continue managing the LLC but under a preliminary injunction that restrains either member from withdrawing LLC funds for himself without the other's consent, or otherwise transferring funds except in the ordinary course of business.
The novelty in Scomello is Justice Pine's appointment of a temporary receiver, not to manage the business, but simply to monitor its financial activities. Here's how she describes the scope of the receiver's duties:
Thus a limited preliminary injunction should remain in effect along with the appointment of a temporary receiver with limited powers to receive monthly statements and back up documents, setting forth all income received and expenses paid by the LLC as well as all member withdrawals and payments of any kind.
Why is this novel? As explained in a decision some years ago by Justice Leonard Austin before his elevation to the Appellate Division, the LLC Law's provisions governing judicial dissolution have no provision for appointment of a receiver until after dissolution is decreed. This omission stands in contrast to §1113 of the Business Corporation Law, which expressly authorizes a court in dissolution cases involving close corporations to appoint a temporary receiver with broad powers to preserve company assets while the dissolution case is pending. An alternative path to receivership for any type of business entity is provided in Article 64 of the Civil Practice Law and Rules, but the courts apply a much more rigorous showing of imminent harm to the business before acting under that Article -- a showing that does not appear to have been made in Scomello.
The monitoring powers granted by Justice Pines in Scomello effectively address a recurring problem in many dissolution proceedings -- not just LLCs -- where one side has little or no access to real-time financial information while the case goes on. Courts often will direct the controlling side to make ongoing disclosure but, almost invariably, new disputes will arise over the adequacy or timeliness of the disclosure. An independent receiver serving only as monitor, acting with the imprimatur of the court, is in a far superior position to enforce disclosure obligations and to convey information the non-controlling side as needed.
Appeals Court Upholds Equitable Buyout Remedy in LLC Dissolution
Last week, in Matter of Superior Vending, LLC, 2010 NY Slip Op 02801 (2d Dept Mar. 30, 2010), the Brooklyn-based Appellate Division, Second Department, affirmed a trial court decision in an LLC dissolution case previously reported in this blog here. The order at issue awarded as an "equitable" remedy the return of the petitioner's capital contribution in exchange for his membership interest in a vending machine business, notwithstanding the court's acknowledgment that there is no buyout remedy in the LLC Law. Instead, the court referred to it as "equitable method of liquidation."
Hmmm, let me get this straight. Petitioner transfers membership interest to respondent. Respondent pays money to petitioner. LLC remains up and running. And that's a liquidation, not a buyout?
Is this another case in which New York courts undermine the contract-based LLC form by super-imposing equitable remedies that only add to the uncertainty surrounding adjudication of LLC disputes and thereby discourage use of the LLC form? Or is it simply a court doing its best to craft a just resolution for the litigants before it based on the peculiar facts presented by the case? Or is it both?
In my prior post I laid out the facts in Superior Vending in abundant detail, so I won't do it again. Here's the summary from the appellate decision, though I warn you it does not nearly do justice to the story:
In 1997 Peter Plotkin incorporated a vending machine company that distributed beverages and snacks to businesses, schools, and hospitals throughout the New York City metropolitan area. In 2000 Arik Tal helped Plotkin to acquire a second vending machine company. Specifically, Tal paid a down payment in the sum of $170,000 and executed a promissory note pursuant to which he agreed to pay the remaining balance of the purchase price in monthly installments. Although Plotkin and Tal formed a limited liability company known as Superior Vending, LLC (hereinafter Superior), to operate the business, they never executed an operating agreement.
Plotkin and Tal, in effect, terminated their business relationship in November 2002. Although Tal initially commenced an action in March 2003, inter alia, to dissolve Superior, he failed to pursue the dissolution claim. That action was marked off the trial calendar in May 2004, and dismissed in May 2005. Meanwhile, Plotkin continued to operate and expand the vending machine business. In June 2007 Tal commenced the instant proceeding pursuant to Limited Liability Company Law § 702, inter alia, to dissolve Superior and recover his share of Superior's assets and interim distributions.
In the lower court proceedings Plotkin consented to the dissolution but contended that Tal was entitled only to half its remaining assets consisting of some old equipment worth a little over $30,000. Tal brought in a business appraiser who testified that the value of Tal's 50% interest ranged up to $700,000 including assets acquired by Plotkin after Tal left the business. Westchester County Commercial Division Justice Alan D. Sheinkman found neither side's position reasonable, and instead ordered that Tal transfer his membership interest to Plotkin in exchange for about $256,000 representing Tal's initial capital contribution plus subsequent note payments with certain offsets. The order further provided for liquidation of the combined businesses in the event Plotkin did not comply. Justice Sheinkman anchored his ruling in § 704(c) of the LLC Law which dictates priority of LLC asset distribution in liquidation.
The Second Department's affirmance devoted all of two sentences to its explanation for upholding the lower court's order, neither of which adds anything significant to the analysis. Here they are:
Although the Limited Liability Company Law does not expressly authorize a buyout in a dissolution proceeding, the Supreme Court properly determined that the most equitable method of liquidation in this case was to provide Plotkin a period of 45 days within which to purchase all of Tal's right, title, and interest in Superior for the principal sum of $256,549.43, plus 9% interest from November 22, 2002 (see Lyons v Salamone, 32 AD3d 757, 758). This approach, which excluded an award of interim distributions made by Superior after November 2002, allowed Tal to recover his investment plus a reasonable return on that investment with respect to his membership interest in Superior, which terminated in November 2002.
The Lyons decision cited in the above passage is another instance in which an appellate court -- in that case, the Manhattan-based First Department -- upheld a somewhat different form of equitable buyout remedy in an LLC dissolution. In Lyons the court granted a contested LLC dissolution petition, after which, over petitioner's objection, it required the two parties to bid against each other to purchase the other's interest. Here's how the court there explained it using the same "liquidation" nomenclature used in Superior Vending:
We reject plaintiff's argument that the absence of a provision in the Limited Liability Company Law expressly authorizing a buyout in a dissolution proceeding rendered the IAS court without authority to grant the parties mutual buyout rights, and find that it is an equitable method of liquidation to allow either party to bid the fair market value of the other party's interest in the business, with the receiver directed to accept the highest legitimate bid.
From a policy standpoint, LLC cases granting equitable remedies as in Superior Vending and Lyons (and let's not forget Tzolis v. Wolff and Gottlieb v. Northriver Trading) should give us pause, however right they may seem as a just disposition of the particular case. A statistical survey recently published by Professor Rodney Chrisman in the Fordham Journal of Corporate & Financial Law shows New York lagging far behind the rest of the country in the rate of new LLC filings compared to the traditional business corporation. The most commonly-cited reason, unique to New York, is the high cost of the legally required public advertisement of the filing of the articles of organization. Many interested observers, including myself, believe that another significant factor is the discomfort level due to the relative unpredictability of outcomes when LLC internal disputes land in court, especially given the large number of LLCs that are formed without written operating agreements. When courts, particularly at the appellate level, resort to uncodified, implied duties and equitable remedies designed to bypass statutory omissions, the uncertainty factor takes on added weight.
At least for involuntary dissolution, the solution is simple. As I proposed some years ago in a NY State Bar Journal article, the LLC Law should be amended to add a buyout election in dissolution cases comparable to § 1118 of the Business Corporation Law. Other states have this feature. It should be made a default rule, subject to any overriding terms of the operating agreement. In other words, the LLC members in the operating agreement would be free to eliminate the right of election upon the filing of a dissolution petition, or to specify the amount or manner of computation of the buyout amount, and the terms of payment.
For those entrepreneurs and investors who would enter into a written operating agreement in any event, the presence of the buyout default rule would further encourage LLC members at the outset to negotiate and draft exit provisions that suit their specific needs and circumstances. For the many LLC start-ups that never get around to making an operating agreement, a statutory default rule granting the right to purchase the dissolution petitioner's membership interest would provide greater certainty, would encourage out-of-court buyout negotiations and, for those disputes that can't be resolved amicably, would reduce the scope of litigation and its attendant costs.
Any legislators out there listening?
Ribstein on Superior Vending: Read here Professor Larry Ribstein's take on Superior Vending.
