Last February, in Tzolis v. Wolff, 10 NY3d 100 (2008), the New York Court of Appeals ruled that members of limited liability companies may bring derivative actions on behalf of LLCs notwithstanding the legislature’s deliberate omission of statutory authorization for derivative actions when it enacted the LLC Law in 1994. (Read my post on Tzolis here).
The dissenting judges in Tzolis objected that the majority had created a common law right of derivative action "unfettered by the prudential safeguards against abuse that the Legislature has adopted when opting to authorize this remedy in other contexts," namely, the statutory provisions imposing demand, contemporaneous ownership, security, attorney fees and settlement restrictions on derivative suits brought on behalf of business corporations and limited partnerships.
The majority responded to this charge, stating that "the right to sue derivatively has never been ‘unfettered’"; that "the limitations on it are not all of legislative origin"; and most importantly:
What limitations on the right of LLC members to sue derivatively may exist is a question not before us today. We do not, however, hold or suggest that there are none.
In Tzolis‘s aftermath, lower courts have taken their cue from the majority’s response by imposing prior demand and contemporaneous ownership requirements on putative LLC derivative plaintiffs.
Demand Requirement Adopted in Evans v. Perl
New York County Supreme Court Justice Judith Gische was the first to weigh in with her ruling in Evans v. Perl, 19 Misc3d 1119[A] (Sup Ct NY County 2008). The plaintiff in Evans asserted derivative claims for an accounting on behalf of a number of LLCs. Defendants moved to dismiss for failure to make or allege a pre-action demand. Plaintiff countered that demand is not necessary in the LLC context and that, in any event, demand would have been futile because the LLCs and the controlling defendant "have no real separate identity."
Judge Gische sided with defendants, concluding that LLC derivative suits should be subject to the same demand/futility requirements applicable to corporations, explaining as follows:
The court rejects [plaintiff’s] argument that, as a matter of law, no prior demand is necessary before a derivative action can be brought against an LLC. This argument rests primarily on the fact that there is no explicit requirement for a demand in the LLC statute. There is, however, no explicit right to bring a derivative action contained within the LLC statute either.
As the Court of Appeals held in the recent case of Tzolis v. Wolff (10 NY3d 100) there is a common law right to bring a derivative action against an LLC. See also: Bischoff v. Boar’s Head Provisions Co. Inc., 38 AD3d 440 (1st Dept. 2007). The common law underpinning of a derivative action is that a faithless trustee refused to bring the action on behalf of the business entity his or herself. Tzolis v. Wolff, supra. Thus the requirement of a demand prior to the institution of derivative litigation is a necessary element of the claim. It is predicated on basic principles of business governance, i.e., that those entrusted with the management of a corporation who have the primary responsibility for acting in the name of the corporation are often in the best position to correct alleged abuses without resort to the courts. BCL §626; Barr v. Wackman, 36 NY2d 371 (1975). There are no cases expressly addressing the issue of the prior demand in the context of derivative actions against an LLC. This is most likely because the right to even bring a derivative action at all was only recently established by the Courts of Appeals. Tzolis v. Wolff, supra. Borrowing, however, from the developed law applicable to derivative actions in a corporate context, the same policy considerations apply and the law applicable to LLCs should be consistent. Thus this court holds that before bringing a derivative action against an LLC for an accounting, the member must make a prior demand on the LLC or otherwise make a showing that such a demand would have been futile.
Justice Gische did not dismiss the claims, however, finding that under the circumstances demand would have been futile.
Contemporaneous Ownership Requirement Adopted in Billings v. Bridgepoint Partners, LLC
Section 626(b) of the Business Corporation Law and Section 121-1002(b) of the Revised Limited Partnership Act require that the plaintiff in a derivative action be a shareholder/limited partner of the corporation/limited partnership at the time of the transaction of which he or she complains, and at the time of bringing the action. The same rule now applies to LLC derivative actions, according to a decison earlier this month by Erie County Commercial Division Justice John M. Curran in Billings v. Bridgepoint Partners, LLC, 2008 NY Slip Op 28351 (Sup Ct Erie County Sept. 19, 2008).
The plaintiff in Billings formed an LLC with two other members in November 2005. In April 2007, the LLC terminated the plaintiff’s employment alleging violations of the operating agreement. A week later, the plaintiff claimed that his interest in the LLC had been constructively terminated and thereupon exercised his rights to withdraw from the LLC and redeem his membership interest for cash payment under the operating agreement’s terms. Plaintiff later brought suit asserting claims against the LLC for breach of the operating agreement along with derivative claims against the other members for improper self-dealing, waste and diversion of LLC assets.
The defendants moved to dismiss the derivative claims on the ground plaintiff was not a member of the LLC at the time he commenced the action. As in Evans, Justice Curran agreed that the common law applicable to LLCs should be guided by the logic and policies underlying the statutory limitations on derivative actions by shareholders and limited partners, writing as follows:
[T]his Court must follow the guidance in Tzolis which requires an analysis of whether there was a contemporaneous ownership requirement at common law and/or a requirement for a demand. . . . The Court is persuaded that the Court of Appeals has provided controlling authority under the common law to impose a contemporaneous ownership limitation upon the right to sue derivatively in the limited liability company context. In Hanna v. Lyon (179 NY 107 ), the Court of Appeals held:
But while the plaintiff Hanna was a stockholder at the time of the commission of the acts of which he complained, he had ceased to be a stockholder at the time of the commencement of the action, and hence was without authority to maintain it. His rights as a stockholder had passed to the subsequent purchaser of the stock, and the Appellate Division was, therefore, right in reversing the judgment as to him and dismissing the complaint. (179 NY at 110-111).
Accordingly, this Court concludes that a member of a limited liability company may sue derivatively, but that such a member seeking derivative relief must have been a member at the time of the offending conduct and at the time the action was commenced. Any other conclusion would be contrary to the analyses in Tzolis and Hanna. Moreover, a contrary conclusion would provide rights to members of limited liability companies beyond the rights afforded under New York law to shareholders of business corporations and limited partners. There is no common law or statutory authority supporting any such conclusion.
The plaintiff in Billings affirmatively alleged that he withdrew from the LLC in April 2007, prior to bringing the action. The operating agreement also provided that a member who withdraws has only a right of future payment. Justice Curran accordingly concluded that the plaintiff lacked standing to assert derivative claims.
The defendants in Billings also relied on plaintiff’s failure to allege demand or demand futility in his complaint. Stating that the court "need not reach the issue of whether a demand is required," Justice Curran nonetheless observed in dicta that, "given the conclusion with respect to contemporaneous ownership requirement, this Court can see no basis upon which to conclude that a demand limitation should not be imposed in the limited liability context similar to what is imposed in the business corporation and limited partnership contexts."
Once Tzolis breached the derivative action barrier, rulings such as those in Evans and Billings, adopting the same limitations on standing as in the corporation and limited partnership setting, were inevitable. Will courts in LLC derivative actions also adopt common law counterparts to the BCL and RLPA rules governing settlement of derivative actions, attorney’s fees, and security for expenses? Stay tuned.
Update November 8, 2010: A decision by New York County Commercial Division Justice Eileen Bransten in Cohen PDC, LLC v. Cheslock-Bakker Opportunity Fund, LP, 2010 NY Slip Op 33108(U) (Oct. 18, 2010), collects and adds to the growing list of cases dismissing derivative actions involving LLCs for lack of standing where the claimant no longer holds a membership interest.
Update November 15, 2010: Read here my post on Justice Bernard Fried’s decision in Eldan-Tech, Ltd. v. Ocelot Capital Management, LLC, holding that the majority member of a manager-managed LLC must comply with the demand requirements notwithstanding a vacancy in the manager position.