A recent decision by New York County Commercial Division Justice Bernard J. Fried addresses issues of interest concerning (a) the standing of an assignee of a member’s economic interest to seek judicial dissolution of an LLC, and (b) grounds for dissolution of a two-member, 50-50 LLC that functioned as a holding company for a non-managing minority interest in another company.

The memorandum decision in Matter of Cline (Private Capital Management, LLC), Index No. 650117/09 (Sup Ct NY County May 29, 2009), grows out of a mega-lawsuit started by Ficus Investments, Inc. (Ficus) against Thomas Donovan, Lawrence Cline and Private Capital Management, LLC (PCM).  PCM, a New York LLC co-owned 50-50 by Donovan and Cline, was the managing 20% member of a Florida LLC called Private Capital Group, LLC (PCG) that purchased, managed and sold non-performing mortgages.  Ficus, which invested $300 million in the venture, held the remaining 80% interest.  In 2007, Ficus terminated PCM as PCG’s manager and brought suit against it along with Donovan and Cline allegedly for misappropriating over $20 million.

Early on Cline settled with Ficus and entered into a cooperation agreement as part of which he conveyed to a Ficus-owned entity called PCM Interest Holding, LLC (Holding) all of Cline’s economic interest in PCM and his irrevocable voting proxy.  Meanwhile, amidst burgeoning litigation proceedings between Donovan and Ficus, in April 2008 Justice Fried ruled that Donovan was entitled to advancement of his legal expenses under PCG’s operating agreement.  Ficus’s appeal from that ruling was rejected in January 2009 (read here my post on the appellate ruling).  In February 2009, Justice Fried also granted PCM’s motion for advancement of its legal expenses.  As part of the same ruling, Justice Fried denied without prejudice a procedurally defective cross-motion by Ficus and nominal defendant Cline seeking judicial dissolution of PCM (read here my post on that ruling).

In March 2009, Cline and Holding responded by filing a separate, new proceeding seeking judicial dissolution of PCM pursuant to Section 702 of the New York LLC Law under which dissolution is warranted “whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement.”  Their petition (read a copy here) alleged that PCM was formed solely to hold Donovan’s and Cline’s 20% interest in PCG; that since the Ficus litigation began, in which Donovan and Cline became adverse parties, the direction and control of PCM is “hopelessly deadlocked”; that Donovan is “misusing PCM for his own tactical advantage” in the litigation; that Donovan and Cline had ceased speaking to one another; and that the plethora of extremely hostile litigations between the two doomed any possibility of restoring the relationship.  Notably, the petition also alleged that PCM lacks a written operating agreement.

Donovan moved to dismiss the petition.  First, he contended that Holding, as transferee solely of Cline’s economic interest in PCM, was not a member and therefore lacked standing to petition for dissolution.  Second, citing the Delaware Chancery Court’s 2008 decision in Seneca Investments LLC v. Tierney (read here my post on Seneca), he contended that deadlock between two 50% managing members of an LLC cannot provide a basis for dissolution where the LLC’s sole purpose is to be a passive investor in another company.  (Read here Donovan’s counsel’s affirmation in support of dismissal of the petition.)

In response, Cline and Holding argued that Section 702 does not require a showing that it is impossible to carry on the LLC’s business, only that it is not reasonably practicable; that the petition’s allegations set forth a “bitterly hostile, intractable and litigious battle” between the two sides; that PCM was formed for the specific purpose of doing business with Ficus; and that such purpose no longer was viable due to the irreconcilable split between Donovan and Ficus.  They also argued that, even though Holding as assignee of Cline’s economic interest was not a member and could not bring a dissolution proceeding on its own, it nonetheless could join Cline’s dissolution petition.  (Read here the opposition memorandum of Cline and Holding).

Interestingly, the issue whether PCM had a valid written operating agreement was raised subsequently, after Justice Fried requested the parties to provide him with copies of PCM’s organizational documents.  Donovan submitted an operating agreement allegedly signed by him and Cline, in which the company’s purpose was stated as “managing the purchase, and resolution of non-performing mortgage as agreed from time to time by the Managers.”  Cline denied signing the operating agreement which he called “fraudulent”.

Addressing first the issue of Holding’s standing, Justice Fried agreed with Donovan that Holding lacked standing to join the petition for dissolution.  Sections 603 and 604 of the LLC Law make it clear that, except as provided in the operating agreement, the assignee of a membership interest does not become a member of the LLC without the consent of the remaining members and is entitled only to the economic rights of the assignor to the extent assigned.  Under Section 702, only a member has standing to seek dissolution.

Justice Fried nonetheless granted the dissolution petition, holding that Cline — whose standing as a member was not contested — had established

that it is not reasonably practicable to carry on PCM’s business in conformity with the articles of organization or operating agreement thereby warranting dissolution.  That Cline and Donovan dispute whether there exists an operating agreement for PCM, and Cline asserts that the purported operating agreement for PCM that Donovan submitted is fraudulent, is indicative of the litigious nature of their relationship.  Dissolution is warranted regardless of the validity of PCM’s purported operating agreement. [Citation omitted.].

According to Cline, in addition to the absence of a PCM operating agreement, PCM never followed corporate formalities, and it is merely an alter ego for Cline and Donovan.  PCM’s sole function is to hold their 20% interest in PCG.  Thus, because of the acrimonious nature of the parties’ business relationship, and the fact that dissolution will not interfere with an on-going business, dissolution is justified.  

Even were he to find the operating agreement submitted by Donovan valid, Justice Fried added, it would further support dissolution in that the purpose clause (quoted above) “is inconsistent with Donovan’s assertion that PCM was formed merely as a passive investment entity, and it would entail even more cooperation between the members as would be the case under Cline’s characterization of PCM’s purpose.  Either way, dissolution is warranted.”

In the Seneca case relied upon by Donovan, the Delaware Chancery Court dismissed a dissolution petition brought by a minority member of a Delaware LLC who asserted that the company had ceased all active business operations.  The company retained passive investments worth over $2 million.  The Chancery Court looked to the operating agreement’s broad purpose clause, which included “any lawful act or activity,” and concluded that the company’s status as a passive investment holding company was consistent with its stated purpose.

Are Seneca and Cline reconcilable?  One can argue they are, based on the fact that Cline was a deadlock petition brought by a 50% member whereas Seneca was brought by a non-controlling member who therefore was forced to make the harder argument that, even with effective majority control, the company could no longer operate consistent with its broad purpose clause.  In addition, if it is assumed that PCM’s operating agreement is valid, its narrow purpose clause (“managing the purchase, and resolution of non-performing mortgage as agreed from time to time by the Managers”), subsequently rendered unattainable by Ficus’s expulsion of PCM as manager of PCG, is materially different from Seneca‘s broad purpose clause.  If, on the other hand, PCM’s operating agreement is deemed invalid, and therefore by statutory default the company’s purpose is deemed to be “any lawful business activity” (LLC Law Section 201), it becomes a closer argument, but only if it is further assumed that the antagonism between Cline and Donovan would not interfere with PCM’s reduced, passive role as the recipient of distributions and profit and loss allocations as 20% member of PCG.  

One final note on procedure.  In opposing dissolution, Donovan opted as permitted by CPLR Article 4 (governing special proceedings) to make a motion to dismiss the petition for failure to state a valid claim for dissolution, and requested leave to file an answer in the event the court denied his motion.  Such leave is discretionary (CPLR 404[a]) and therefore always entails some risk that the court will grant the petition summarily, particularly when the respondent does not submit client affidavits or other evidentiary materials contesting the petition’s factual allegations.