“Except as provided in the operating agreement. . . ”

By my count, this phrase and its close relative, “unless otherwise provided in the operating agreement,” appear 59 times in New York’s LLC Law, most often to qualify a rule on LLC governance.  This substantial deference to the members’ freedom of contract is a hallmark of LLCs, and it is often said that the LLC law contains default rules, or “gap fillers,” subject to the members’ rights to modify the rules as they see fit.

The interplay between the default rules and the members’ agreement sometimes gets complicated.  For instance, when an operating agreement is completely silent on a right set forth in the LLC law, that silence can be ambiguous.  Were the parties silent about that right in their operating agreement because they agreed to forgo it?  Or does their silence in the operating agreement mean that the members wished to apply the default rules?

This difficult question took center-stage in a duo of recent decisions from Manhattan Commercial Division Justice Joel M. Cohen, in McCormack v Kuras, Index No. 656434/2021 [Sup Ct, New York County] and its related case, Triboss Brooklyn LLC v Kuras, Index No. 654282/2021 [Sup Ct, New York County]).

In these decisions, Justice Cohen rejects the majority members’ attempts to remove a managing member from management.  In so doing, Justice Cohen recognizes the appeal of both sides’ arguments and takes the relatively rare step of expressly inviting appellate guidance on issues surrounding the applicability of the LLC law’s default rules.

Continue Reading A Two-Act Play of LLC Default Rules and Manager Removal

Are claims for judicial dissolution of business entities arbitrable?

It’s a question I’m occasionally asked by business owners and, surprisingly, by lawyers. I say surprisingly because here in New York, the courts long ago settled the question in favor of arbitrability. But there are some nuances when it comes to judicial dissolution and arbitration, and the arbitrability of dissolution claims is not a given in all states.

What follows is a very basic explanation of the rules and some issues surrounding arbitration of judicial dissolution claims. Bear in mind, however, that the governing rules, whether statutory or judge-made, can vary significantly from state to state, so whether you’re a business owner or a lawyer representing one, be sure to consult the rules in your jurisdiction.

How Do Business Entities Get Dissolved?

It may not be obvious why I pose this question first. Let me explain.

Corporations, limited liability companies, and limited partnerships — I’m purposely omitting general partnerships — are state-enabled creatures that draw their first breath only upon meeting statutory filing requirements with the Secretary of State. They likewise draw their last breath upon filing the statutorily specified documentation requiring the Secretary of State to dissolve the entity.

Business entity dissolution is governed by statute and comes in two flavors: voluntary (i.e., non-judicial) and involuntary (i.e., judicial). In the case of voluntary dissolution, the statutorily required filing consists of an authorized certificate of dissolution. Involuntary dissolution requires the filing of a court order directing the Secretary of State to dissolve the entity. Continue Reading The Skinny on Arbitrability of Judicial Dissolution Claims

The books and records proceeding often is the first time that a dispute between a minority shareholder and the majority enters the courtroom. Suspicious of misconduct or mismanagement, the minority shareholder demands to inspect certain records of the corporation, and the majority in control of those records, offended by the suggestion, stonewalls. Enter the books and records proceeding: a special proceeding under Article 4 of the CPLR which allows a court to summarily order the corporation to make the requested records available to the shareholder.

This blog has covered several decisions—including the First Department’s McGraw Hill and several 2018 cases—highlighting the expansion of the New York books and records proceeding from an ineffective use of time and resources to a more potent option in the minority shareholder’s playbook.

While the books and records proceeding is now a relatively speedy and cost-effective tool for the minority shareholder investigating misconduct or otherwise contemplating litigation against the majority, we see many cases where the petitioner gets tripped up in the web of different inspection rights and their correspondingly different scopes, conditions precedent, and required justifications.

Last month, Justice Platkin of the Albany County Commercial Division issued a decision in Galasso v Cobleskill Stone Products, Inc., 73 Misc 3d 1231(A) [Sup Ct 2021], providing an excellent primer on the statutory and common law regimes governing access to a corporation’s records and the different evidentiary showings required. The decision also sheds light on whether minority shareholders in a valuation proceeding—such as that conducted under BCL 1118 or 623—are entitled to access records of the corporation post-dating the applicable valuation date. Continue Reading Justice Platkin’s Primer on Shareholders’ Inspection Rights

If you ask me to name the most common skirmishes over the adequacy of pleadings at the outset of business divorce litigation, at or near the top of the list are motions to dismiss a dissident owner’s direct claims that should have been brought derivatively, or derivative claims that should have been brought directly, or claims pleaded as both direct and derivative.

The frequency of such motion practice contrasts with the simplicity of the two-factor test devised by the courts for determining whether a claim is direct or derivative. As stated by the Appellate Division, First Department in Yudell v Gilbert, borrowing from the Delaware Supreme Court’s Tooley formulation, the determination depends on “(1) who suffered the alleged harm (the corporation or the stockholders); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders individually).”

The test sounds easy to apply, and in most cases it is, especially when the alleged wrongful conduct by a controller involves misuse or waste of company funds or other financial impropriety that affects the nonculpable owners indirectly and on a shared basis by devaluing their equity interests. While the nonculpable owners of a closely held business may be victimized in a very real sense by the controller’s alleged misconduct, the direct injury is to the company for which the company is entitled to any recovery. Stated differently, the claim is company property, the prosecution of which normally depends on the business judgment of those holding the company’s managerial reins, and therefore can only be asserted by the non-managerial owners as a derivative claim after making demand upon the company managers or establishing that demand would be futile.

Let’s look at some recent examples of derivative and direct claims that went astray. Continue Reading Singin’ the Derivative Plaintiff Blues

It’s been another year of important case law developments in business divorce controversies. I’m pleased to present my 14th annual list of the past year’s ten most significant cases.

Consistent with the LLC’s growing dominance in the realm of closely held business entities, six of the cases on this year’s list involve disputes among LLC members over various issues including cash-out merger, arbitration, distributions, dissolution, and capital calls. The remaining cases involving corporations feature decisions addressing Burford abstention in dissolution cases, board elections, shareholder oppression, and buy-sell agreements.

All ten decisions were featured on this blog previously; click on the case name to read the full treatment. And the winners are:

Farro v Schochet  The Appellate Division, Second Department’s January 2021 decision in Farro, in which my firm represented the winning majority LLC members, is bound to have long-lasting consequences for LLC owners and, in particular, for LLCs whose majority members retain statutory default rights to implement cash-out mergers as a means of involuntarily dissociating minority members. In the first of two novel rulings, the appellate panel held that, in contradistinction to the rights of cashed-out minority corporation shareholders under BCL § 623(k) to assert fraud or other unlawfulness as grounds to enjoin or rescind the merger, a cashed-out LLC member’s sole recourse under LLCL § 1002(g) is to dissent and demand a fair-value judicial appraisal. In a second, key ruling the panel held that LLCL § 407(a)’s default rule, authorizing member action by written consent in lieu of meeting, supersedes LLCL § 1002(c)’s requirement of a member meeting on at least 20-days notice to vote on a proposed merger. Also noteworthy is the panel’s decision issued the same date in a companion appeal, dismissing the cashed-out minority member’s derivative claims for lack of standing as of the merger’s effective date (read here). Continue Reading Top 10 Business Divorce Cases of 2021

For owners of closely-held businesses, there are few provisions meriting more attention in an owners’ agreement than the buy-sell agreement.  Buy-sell agreements come in many different forms, and the best ones are designed to address specific concerns of the owners or business.  For example, shotgun buy-sell agreements (like the kind discussed here and here) protect against deadlock of equal managers; death/disability buy-sell agreements (here and here) provide the deceased owner’s heirs with a path to liquidate the estate’s interest; and right-of-first refusal agreements (here) protect against outside ownership of the entity.

This week’s post concerns a corporation’s efforts to enforce the buy-sell provisions of its shareholders agreement with two common (and oft-litigated) provisions: a dissolution-based trigger and a fixed value.  I am especially delighted to blog about Estate of Connie Collins v. Tabs Motors of Valley Stream Corp., No. 160529/2019 (NY County 2021), not only because it sheds light on two hot topics in buy-sell agreements, but also because Peter Mahler and I represent the prevailing parties in the case.

Continue Reading Look Before You Leap: Buy-Sell Agreements Triggered by a Petition for Dissolution

Wyoming enacted the first LLC Act in 1977, creating a hybrid business entity combining partnership features including pass-through taxation with corporate-style limited liability. By the mid-1990s, all 50 states had LLC enabling legislation. Today, over 25% of all U.S. tax filings by business entities are LLCs. As one commentator noted a few years back, LLCs are the “New King of the Hill” among business forms used for privately owned entities.

Professor Susan Pace Hamill, who since 1994 teaches business and tax law at the University of Alabama, was in the vanguard of lawyers who, from the start, understood the significance and potential of this new form of business organization. First in private practice in New York City, then in the Chief Counsel’s Office of the IRS, and ever since in academia, Professor Hamill has been a keen observer, historian, influential voice, and prolific author of law review articles on LLCs and other “biz org” topics, interspersed with a run for legislative office in her home state of Alabama and public interest advocacy challenging that state’s property tax structure on race-based equal protection grounds.

I recently had the pleasure of interviewing Professor Hamill for the Business Divorce Roundtable podcast about her latest law review article published in Volume 51 of the Cumberland Law Review, entitled Some Musings as LLCs Approach the Fifty-Year Milestone. The article discusses the origins of the LLC movement, the transformation (or, as Professor Hamill might put it, mutation) of LLCs to more closely resemble their corporate cousins, and some of the problems on the horizon for LLCs that she believes require federal intervention. From the article’s abstract:

In less than twenty years, limited liability companies, or LLCs, became the fastest growing business organization form in the United States and indisputably emerged in the mainstream alongside corporations and partnerships.  In 2017, the most recent year for which IRS Statistics of Income figures were available, 2,696,149 LLCs filed returns with the Internal Revenue Service (the “IRS”).  This number represents well over three times the number of LLCs that filed returns in 2000.  In 2017, over one-fourth of the more than ten million total business organizations were LLCs, an impressive increase when compared to LLCs accounting for 10% of all business organizations in 2000.  Over this period, general and limited partnerships became less significant.  Although corporations still accounted for the majority of business organizations filings in 2017, the percentage of business organizations filing as corporations dropped by almost 10% when compared to the 2000 filings, and many of those businesses chose to become corporations before LLCs became widely available and are now stuck there—a situation I describe as the “Hotel California effect.”  These figures, along with the explosive growth of LLCs compared to an overall decrease of corporations, predict that the gap between the number of businesses conducted as corporations and LLCs will continue to close in the future.

Primarily aimed at readers who are not experts, this article identifies what makes LLCs so special and how they traveled from obscurity to the mainstream so quickly.  It also highlights business law issues and abusive practices exposed by the current use of LLCs and explains why these problems are not caused by LLCs.  Finally, this article demystifies the challenges of teaching and understanding LLCs within the framework of all business organizations.

Simply put, LLCs are the first domestic business organization form to combine direct corporate limited liability and partnership tax status.  The LLC’s creation and characteristics can be best understood as a dance between state and federal law.  Despite broad federal power under the Commerce Clause and business being a quintessential example of interstate commerce, state law authorizes business organization forms and dictates the provisions in each business organization statute, and state courts interpret those laws.  When determining the federal income tax consequences to the business organization and its owners, federal tax law largely yields to state law, notwithstanding the spirit of the Supremacy Clause.  Business organizations designated by state law as corporations are taxed at both the entity and shareholder levels or, if the corporation qualifies for and properly elects to be taxed as a small business corporation, at the shareholder level under a modified flow-through regime with many restrictions.  Business organizations designated by state law as “unincorporated,” including partnerships and LLCs, are almost always taxed as partnerships under a complete flow-through regime free of the many traps that plague corporations.

I know from my own business divorce practice the importance of understanding the nuances of the legislative scheme governing LLCs, the often complex interplay between LLC statutory default rules and operating agreements, and the differences between statutory and judicial treatment of the rights and remedies available to minority members of LLCs, the latter being a topic that draws the pique of Professor Hamill in her article and in the interview.

All of which and more is discussed in a lively conversation with Professor Hamill which you can hear by clicking on the below link.

Michael D. Cohen, former personal attorney and self-described “fixer” for Donald J. Trump, was ubiquitous in the national news throughout much of Trump’s administration as President of the United States. Cohen’s estrangement from Trump dominated the news cycle for years. He once publicly said he would “take a bullet” for Trump, but eventually pleaded guilty to several federal crimes and cooperated with multiple investigations into various activities surrounding Trump’s presidential campaign and administration.

A less publicized aspect of Cohen’s relationship with Trump was that he was also an employee – and according to Cohen, Executive Vice President and Special Counsel – of the Trump Organization LLC (“Trump Organization” or the “Company”).

As we’ve written often (you can read some articles on the subject here, here, and here), under certain circumstances, managers, members, officers, directors, and even ordinary employees of New York business entities can potentially recover advancement or indemnification of legal fees incurred in defense of lawsuits brought against them for actions taken for or on behalf of the business.

“Advancement” refers to a business funding a legal defense while the legal proceeding is underway. “Indemnification” refers to the business paying the defense (and any damage award) when the proceeding is concluded – including often a ratification of its prior advancement. The right to advancement and indemnity depends primarily on two things: the kind of entity involved (LLC, corporation, or partnership) and whether there is an applicable contract. For New York limited liability companies like the Trump Organization, Section 420 of the Limited Liability Company Law (the “LLC Law”) governs advancement and indemnification of legal fees, providing that the operating agreement “may” – but is not required – to provide its principals, agents, or any “other person” advancement or indemnification rights.

In March 2019, around the time Cohen’s legal problems were at their apogee, and just two months before he reported to federal prison, Cohen brought a lawsuit in Manhattan Supreme Court in his capacity as an employee and alleged officer of the Trump Organization for indemnification by the Company for millions of dollars of legal fees he incurred from a dizzying array of civil, administrative, and criminal lawsuits against him resulting from various activities he allegedly undertook on behalf of Trump. Cohen’s lawsuit culminated in a fascinating decision last week from Manhattan Commercial Division Justice Joel M. Cohen, Cohen v Trump Org. LLC, 2021 NY Slip Op 32281(U) [Sup Ct, NY County Nov. 12, 2021], exploring three limits New York law imposes upon the ability to recover LLC indemnification. Continue Reading The Outer Limits of LLC Indemnification: Michael Cohen v Trump Organization

Two years ago, Peter Mahler wrote about a dissolution lawsuit by a female minority shareholder alleging that her male co-shareholders condoned a pattern of sexually offensive and demeaning conduct by a senior co-worker, which ultimately forced her to leave the business.

In Matter of Straka v Arcara Zucarelli Lenda & Assoc. CPAs P.C., 62 Misc 3d 1064 [Sup Ct, Erie County 2019], the court ruled that “disrespectful and unfairly disproportionate treatment of a female shareholder by the male majority in a closely held corporation constitutes oppression” and grounds to dissolve a corporation under Section 1104-a of the Business Corporation Law.

In a bizarre plot worthy of a Hollywood scriptwriter’s imagination, a court last month issued a decision in a case with a reverse fact pattern: a claim by an elderly male shareholder, Felix Glaubach (“Glaubach”), alleging that he was victimized by false allegations of sexual harassment concocted in an extortionate scheme by the company’s chief executive officer and the officer’s wife. Different branches of the same sprawling litigation have been featured on this blog twice. Continue Reading #MeToo and Business Divorce: The Flip Side

For the second time in two years, the Connecticut Supreme Court has ventured into uncharted waters of LLC governance under the Revised Uniform LLC Act which, to date, has been adopted by 22 states and awaits legislative approval in two more.

Last year, the Court in Manere v Collins reversed an order dismissing a minority member’s oppression-based claim for judicial dissolution on the ground that the lower court applied the incorrect legal standard. Observing that “[n]o court has had the occasion to directly address the issue of which test applies to claims of oppression pursuant to the RULLCA,” the Connecticut court held that oppression as that undefined term is used in RULLCA should be evaluated under the “reasonable expectations” test applied by most states, including New York, under their close corporation dissolution statutes. The court rejected the more demanding “fair dealings” standard which prominently considers whether the majority’s conduct was in furtherance of a legitimate business purpose. For more on Manere, read here Professor Dan Kleinberger’s analysis of the case and here my post on the Iowa Supreme Court’s Barkalow decision last May in which it agreed with and adopted the reasonable expectation factors prescribed in Manere.

Earlier this month, in Benjamin v Island Management LLC, the Connecticut Supreme Court again broke new ground under RULLCA, interpreting its provisions governing the rights of members in manager-managed LLCs to inspect books and records. The court’s key ruling held that a member of a manager-managed LLC who demands inspection of books and records for the stated purpose of investigating mismanagement need not come forward with “credible proof” of mismanagement in order to satisfy RULLCA’s requirement that the member “seeks the information for a purpose reasonably related to the member’s interest as a member.”

In so ruling, the court in Benjamin explicitly rejected Delaware’s more restrictive standard under that state’s statutes governing inspection rights both of shareholders and LLC members — see, for example, former Chancellor Bouchard’s decision in Riker v Teucrium Trading, LLC — requiring the investor to “show, by a preponderance of the evidence, a credible basis from which the [court] can infer there is possible mismanagement that would warrant further investigation.” The court also dispensed with Delaware’s strict necessity test requiring a plaintiff to prove that each category of books and records is essential to the inspection’s stated purpose. Continue Reading The Nutmeg State Out Front on Member Inspection Rights Under RULLCA