I’ve previously featured LLC member disputes in which the defending side achieves a potentially decisive tactical victory by saddling the complaining side with some or all of the defending side’s legal expenses via indemnification and advancement provisions in the operating agreement and under LLC Law Section 420 (see here and here).
The Appellate Division, Second Department’s recent decision in Fuiaxis v. 111 Huron Street, LLC, 58 AD3d 798 (2d Dept Jan. 27, 2009), presents a variation on the same theme, this time highlighting the controlling faction’s successful reliance on the operating agreement’s compulsory capital contribution provisions to force the complaining member to subsidize his opponents’ legal defense.
George Fuiaxis is one of four members each with a 25% interest in a real estate company called 111 Huron Street, LLC. An earlier lower court decision in the case indicates that Fuiaxis sued under LLC Law Section 702 to dissolve the LLC after he elected to withdraw, alleging that it was no longer reasonably practicable to carry on the business because of his withdrawal or, alternatively, due to "internal deadlock" between him and the other three members. (Alas, the decision does not address how Fuiaxis had standing to seek dissolution after his withdrawal, or how the 25%-75% alignment created deadlock.)
Some months after Fuiaxis brought suit, the three other members approved a resolution requiring all members including Fuiaxis to contribute $10,000 each to be used as an advance to the LLC for its legal expenses in defending against the dissolution action and to pay municipal fines for boiler related violations. They sent a demand to Fuiaxis explaining that it was being made pursuant to paragraph 17 of the LLC’s operating agreement, which provides:
From time to time, Members will be required to make cash contributions to the Company for purposes as determined by the [Managing] Committee. Should a member fail to make the called for contribution within ten (10) days of the date set for the contribution by the Committee, any other Member may purchase the Percentage Ownership of the defaulting Member at a sum equal to six (6) time[s] the annual current legal gross rent roll divided by four (4) minus one quarter (1/4) of the outstanding debt of the Company.
Fuiaxis moved for a preliminary injunction prohibiting the other members from enforcing the demand (which, by the way, implies Fuiaxis’s belief that the buyout formula in paragraph 17 constitutes less than 25% of liquidation value). The trial court denied the motion on the ground that the demand was authorized under the indemnification statute, LLC Law § 420. On appeal, the Second Department affirmed on a different ground, stating as follows:
Here, the three individual defendants, who comprise three of the four members of the LLC’s managing committee, approved the demand that each LLC member contribute $10,000 because of legal expenses incurred in defending the instant litigation and substantial fines imposed by the City of New York for boiler-related violations. As such, the demand was proper pursuant to paragraph 17 of the LLC’s operating agreement. In turn, paragraph 17 is consistent with the Limited Liability Company Law, which does not preclude a limited liability company from using its funds to defend itself in a judicial dissolution action (see LLCL 502[a], [c]).
On this record, it is not clear whether Limited Liability Company Law § 420, which concerns indemnification, applies to the case at bar. In any event, even if it is applicable, it would not bar the subject demand (see Van Der Lande v. Stout, 13 AD3d 261).
The appellate court’s distinction between LLC Law Section 420 (indemnification) and LLC Law Section 502 (liability for contributions) is important. The former deals exclusively with the LLC’s power to indemnify members and managers for claims against them, and to advance their expenses. Section 420 contains a caveat, however, that no indemnification may be made if there’s a final adjudication adverse to the member or manager establishing that his or her acts were committed in bad faith or were the result of active and deliberate dishonesty, or that he or she gained a financial profit or other advantage to which he or she was not legally entitled. In other words, the member or manager whose expenses are advanced remains at risk of having to reimburse the LLC in the event of an adverse outcome.
Section 502, on the other hand, concerns enforcement of a member’s promise to contribute cash or property, or to perform services for the LLC, for any business purpose. Such promise may be embodied inside or outside the operating agreement. Under Section 502(c), the operating agreement may specify the consequences of a member’s failure to contribute, including a reduction of the member’s interest, a forced sale of the interest, or even a forfeiture of the interest. Paragraph 17 of the operating agreement in Fuiaxis tracks the authority granted in Section 502(c) and leaves the plaintiff with no ability to recover the demanded cash contribution even if he ultimately prevails in his lawsuit and establishes misconduct by the controlling members.
I have not seen the complaint in the Fuiaxis case and therefore do not know if any claims are asserted against the LLC itself, or if any coercive relief is demanded against the LLC, or if there are separate claims pleaded against the other three members named as defendants. As quoted above, the Second Department’s ruling specifically notes that the LLC Law does not preclude an LLC from "using its funds to defend itself in a judicial dissolution action." That’s an interesting statement, because in the usual dissolution proceeding the entity is a nominal party, a bystander; the fight is between the co-owners and, while the LLC is obligated to appear by an attorney, such representation should be neutral as amongst the individual members. Taking the statement at face value, I suppose the plaintiff in Fuiaxis at least can take some comfort that the cash he’s required to contribute may not be used in the defense of any claims against the individual members although, as I said, it’s not clear from the decision whether there are distinct claims and separate defense representation.
Update October 25, 2010: Read here my post on Georgi v. Polanski, where the Kings County Commercial Division held invalid a capital call in contravention of the operating agreement.