When 50-50 business partners have a falling out, the ensuing battle for the high ground can lead one of them to take hostile action in the company’s name without the other’s consent.

Examples of the phenomenon, recently featured in this blog, include the case of Hellman v. Hellman, where the court upheld the authority of a 50% shareholder as president to enter into a lease opposed by the other shareholder, and Sports Legends, Inc. v. Carberry, where the court refused to authorize a lawsuit brought in the company’s name by one 50% shareholder against the other.

Then there’s Caplash v. Rochester Oral & Maxillofacial Surgery Associates, LLC.  About four months ago I wrote about an appellate decision in the Caplash case in which the court reversed a trial court order dissolving a medical practice LLC because of unresolved factual issues concerning the plaintiff’s standing to seek dissolution.  The issue before the court was whether to give legal effect to the plaintiff’s letter to the company resigning his employment, and thereby terminating his LLC membership, where the company’s requisite acceptance of the resignation was by letter from an attorney whose authority under the operating agreement to act on the company’s behalf was not established.  The appellate court sent the case back to the trial court for a hearing to determine the issue.

Since then, there’s been a flurry of activity in the Caplash case and a new trial court decision (reported at 19 Misc 3d 1138(A)) which, I’m happy to report, supplies many of the underlying facts missing from the appellate decision.  The recent decision, by Justice Kenneth R. Fisher of the Monroe County Supreme Court, Commercial Division, addresses two issues of interest.  First, it examines the interplay between the parties’ operating agreement and the LLC Law in deciding whether the lawyer engaged by one member with 50% voting power had the authority to accept on the LLC’s behalf the other member’s resignation.  Second, it determines whether the same lawyer could act on the entity’s behalf in asserting claims against the resigning member for wrongful competition and other economic injury to the LLC.

The Facts and Litigation Proceedings

The facts in Caplash portray a medical practice buyout gone seriously awry almost from the get-go.  The practice initially consisted of Drs. Vernon Loveless and Mohammed Salahuddin.  Along comes Dr. Jolly Caplash who agrees to purchase Dr. Loveless’s membership interest and gives him a $400,000 promissory note on which he makes only two payments before things start to fall apart.  Dr. Caplash accuses Dr. Loveless of hiding certain problems in the business including strife between Drs. Loveless and Salahuddin.  He also alleges that Dr. Loveless had foreknowledge that Dr. Salahuddin would interfere with Dr. Loveless’s introduction of referring doctors to Dr. Caplash, and that he failed to disclose Dr. Salahuddin’s intention to leave the practice.

In 2006, Drs. Loveless and Caplash filed separate lawsuits, the former to recover from Dr. Caplash on the promissory note and against Dr. Salahuddin for tortious interference, and the latter against Dr. Salahuddin seeking a declaratory judgment that Dr. Caplash is president and CEO of the LLC.  Dr. Caplash’s complaint named the LLC as a party defendant but sought no relief against it.  Dr. Salahuddin’s original answer (I’m guessing it was filed prior to Dr. Caplash’s disputed resignation letter in December 2006) asserted derivative counterclaims against Dr. Caplash and also sought to dissolve the LLC.  Dr. Salahuddin’s amended answer (I’m guessing it was filed after the resignation letter) dropped the dissolution counterclaim.

Dr. Salahuddin also hired his personal attorney to represent the LLC to defend it in the declaratory judgment action.  The attorney filed an answer by the LLC with counterclaims seeking a money judgment against Dr. Caplash for wrongful competition, failure to remit earnings to the LLC, and improper use of a company credit card.

Following the appellate court’s remand, Justice Fisher commenced a hearing and took testimony of Dr. Salahuddin’s lawyer concerning his authority to act on the LLC’s behalf.  The court then issued an order inviting a motion directed to the issues: (1) the propriety of the LLC’s interposition of a counterclaim for dissolution, (2) whether the LLC’s participation in the case had improperly assumed a militant alignment on the side of one of two co-equal members, and if so (3) whether the LLC’s funds were properly being used for litigation expenses.

FIVE motions followed.  Of interest here are two of them:  Dr. Salahuddin’s motion for summary judgment closing the evidentiary hearing and declaring that Dr. Caplash has no standing to seek judicial dissolution, and the LLC’s motion for summary judgment on its counterclaims against Dr. Caplash.

The Court Refuses to Close the Hearing or Declare that Dr. Caplash Lacks Standing

Dr. Salahuddin argued that, under Section 401 and Section 412 of the LLC Law, he had the authority as an agent of the LLC to hire counsel who in turn could accept on the LLC’s behalf Dr. Caplash’s December 2006 letter of resignation.  Justice Fisher found two insuperable problems with the argument.  The first was the appellate court’s "unequivocal direction to hold a hearing" which, Justice Fisher observes, "is not lightly discarded in favor of summary disposition, even at the behest of the party which originally opposed the summary judgment motion reviewed by the Appellate Division".  Second, Justice Fisher writes that Dr. Salahuddin’s contention

is fully undermined by the provisions in the Operating Agreement for management of the company by its officers . . ., including a President who is by the Operating Agreement given unrestricted authority as "Chief Executive Officer of the Company" to engage in "the general management of the affairs of the company" in the absence of contrary "direction of the members"’.

Here, the default provisions in LLC Law Sections 401 and 412, vesting management in the members in the absence of contrary provisions in the operating agreement, are trumped by the Operating Agreement’s plenary delegation of management authority to the LLC’s President, subject only to duly adopted member directive.  As Justice Fisher explains further:

The structure of this operating agreement compels the conclusion that ROMSA is a manager-managed LLC and not a member-managed LLC unless the members take action at a duly convened meeting or by written consent.  [Citations omitted.]  Similarly, Salahuddin’s contention that he was an agent of ROMSA for the purpose of hiring counsel for the entity to defend it against a simple declaratory judgment action relative to the June 2006 members meeting and election, and thereby to convert ROMSA’s status in that action as a mere nominal defendant into an active litigant on one side of this 50-50 membership dispute (complete with counterclaims against the other 50% member) is wholly misplaced.  Section 412(a) speaks only of an agency "for the purpose of . . . [an LLC’s] business" and the execution of instruments "for apparently carrying on in the usual way the business of the limited liability company."  It does not address the extraordinary transformation of an LLC as a nominal defendant in a declaratory judgment action into an active litigant against one of its members.

Based on the documentary evidence and the testimony of Dr. Salahuddin’s lawyer, were the hearing to be closed, it was clear that Dr. Salahuddin was not President of the LLC and therefore did not have the authority to hire LLC counsel to accept Dr. Caplash’s letter of resignation.  Posing an ironic twist, Justice Fisher also notes that:

At the time, Salahuddin might have himself accepted the resignation as the only other member of ROMSA, but there is no evidence that he did so before the motion for dissolution was argued or before Caplash subsequently rescinded his resignation.  In any event, Salahuddin had at the time interposed a counterclaim for dissolution and a motion for the same in the Caplash action, thus implicitly recognizing Caplash’s membership status, a recognition that was not withdrawn until Salahuddin decided at the eleventh hour to withdraw his motion for dissolution.

The Court Summarily Dismisses the LLC’s Counterclaims

Justice Fisher employs a dual analysis with respect to the LLC’s active participation as counterclaimant in the litigation brought by Dr. Caplash for declaratory relief.  Each one leads to the same conclusion, namely, that Dr. Salahuddin had no authority to engage entity counsel who had no authority to pursue litigation in the LLC’s name against one of the LLC’s two co-equal members.

First, based on his prior finding that the LLC is manager-managed in the absence of duly authorized action of the members, he concludes that Dr. Salahuddin as a 50% member had no authority to hire counsel to represent the LLC.  "No evidence has been adduced", writes Justice Fisher, "that a meeting of ROMSA was held during which the retainer was authorized by a vote of the members, nor is there any evidence that the initiation of a lawsuit in the entity’s name against one of its members was duly authorized".

Second, even assuming Dr. Salahuddin was president of the LLC at the relevant times, Justice Fisher finds that:

he had no authority to hire counsel for ROMSA for the purpose of prosecuting in the LLC’s name an action against a co-equal 50% member; the sole remedy was the derivative suit he instituted by way of his own counterclaim. See Stone v. Frederick, 245 AD2d 742, 744-45 (3d Dept. 1997)(collecting authorities), discussed in Hellman, supra, slip opn. at 12. Contrary to Kristal’s repeated characterization, Caplash did not sue ROMSA. Drawing an analogy from the partnership context, "[s]ince this is a dispute between partners over the interpretation of the rights and obligations under the partnership agreement, it is not a proceeding by or against the partnership [citation omitted], even though the partnership is made a nominal party plaintiff."  Tesco Properties, Inc. v. Troy Rehabilitation and Insp. Project, Inc., 166 AD2d 839, 841 (3d Dept. 1990). [Footnote omitted.]

For these reasons, and invoking the court’s authority on a summary judgment motion to search the record and grant judgment to the non-moving party, Justice Fisher granted summary judgment dismissing all counterclaims interposed by the LLC.

No doubt about it, the Caplash scorecard is a messy one.  In a portion of the decision redacted from the published version, the court rejected Dr. Caplash’s fraudulent inducement defense and granted Dr. Loveless summary judgment enforcing Dr. Caplash’s $400,000 note obligation.  I suspect this one will go a few more rounds before it’s over.