Two cases do not a trend make, but I can’t shake the feeling that the Brooklyn-based Second Department appeals court has clamped down on the era of freewheeling judicial remedies in business breakup cases involving limited liability companies.
As I reported here, last January the Second Department issued a major ruling in the 1545 Ocean Avenue case articulating a new, tougher standard for LLC dissolution, in line with the Delaware approach, in which freedom of contract and fidelity to the operating agreement are paramount. Earlier this month, the Second Department issued another significant ruling in Chiu v. Chiu, 71 AD3d 646, 2010 NY Slip Op 01768 (2d Dept Mar. 2, 2010), holding that courts have no statutory authority to order expulsion of an LLC member for alleged misconduct, absent language in the operating agreement expressly providing for an expulsion remedy. In so ruling, the court turned its back on the appellant’s argument that judicial expulsion should be recognized as a common law remedy under the reasoning of the Court of Appeals’ 2008 decision in Tzolis v. Wolff, 10 NY3d 100, where it divined a common law basis for LLC derivative actions.
Chiu arises from a bitter family dispute between older brother Winston Chiu (WC) and younger brother Man Choi Chiu (MCC) featuring multiple lawsuits over a real estate holding limited liability company called 42-52 Northern Blvd., LLC formed in 1999. The property was purchased for approximately $5.5 million. The LLC had no written operating agreement. The LLC’s 1999 and 2000 tax returns identified WC and MCC as holding 25% and 75% interests, respectively. Under a 1999 agreement, WC had certain rights to purchase the 75% interest held by his brother.
After disputes erupted, in 2001 WC unilaterally prepared a deed transferring the LLC’s real property to his personal trust. In 2002, MCC sued WC and the trust to set aside the conveyance as fraudulent. After a trial the court entered judgment in MCC’s favor voiding the property transfer and also declaring that WC was "never a member" of the LLC and that MCC was its "sole member". On WC’s subsequent appeal, the Second Department issued a ruling in 2007 (reported at 38 AD3d 619) upholding the avoidance of the property transfer but reversing the judgment’s negation of WC’s membership interest in the LLC based largely on the tax returns.
MCC then started another lawsuit against WC asserting two claims: first, seeking a declaration of the brothers’ respective ownership rights in the LLC and an accounting by WC in the event WC is determined to have an interest, and second, seeking a judgment removing WC as a member of the LLC based upon his alleged misconduct and breach of fiduciary duty surrounding the previously adjudicated fraudulent conveyance.
By decision and order dated March 11, 2008, Queens County Supreme Court Justice James P. Dollard partially dismissed MCC’s first claim, insofar as it sought to characterize WC’s interest in the LLC as "nominal," on res judicata and collateral estoppel grounds stemming from the Second Department’s 2007 ruling. Of more interest, Justice Dollard granted WC’s request to dismiss the second claim seeking his expulsion from the LLC, holding that the LLC Law does not authorize judicial removal of a member absent provision for removal in the operating agreement.
In between the submission of WC’s dismissal motion and Justice Dollard’s decision, the New York Court of Appeals (the state’s highest court) decided the Tzolis case by 4-3 vote in favor of an LLC member’s common-law right to bring derivative claims notwithstanding the legislature’s deliberate omission of a statutory right of derivative action. In June 2008, MCC moved for reconsideration of the order dismissing his claim to expel WC, arguing that Tzolis represented a change in the law authorizing the court to devise an expulsion remedy for member misconduct even absent express statutory authority.
By order dated July 7, 2008, Justice Dollard denied MCC’s motion, writing that the Tzolis majority relied on
the long common law history of derivative actions . . . but in the case at bar, plaintiff MCC did not show that there is a common law basis for the expulsion of a member of a limited liability company or even for the expulsion of a partner [in a partnership].
MCC thereafter appealed from the dismissal of his claim seeking to expel WC. MCC’s brief on appeal (read here) raised two arguments. First, he rested judicial authority to grant the expulsion remedy on §701 of the LLC Law which expressly references the "expulsion" of a member (amongst other events including bankruptcy, death, dissolution, incapacity and withdrawal) as triggering the non-judicial dissolution of the LLC unless the remaining members authorize its continuation. (The statute was "flipped" by legislative amendment effective after the formation of the subject LLC, to provide for continuation of the LLC following such events unless the remaining members vote to dissolve.)
MCC devoted the greater part of his brief to his second argument based on Tzolis. Essentially, MCC argued that under Tzolis the courts have broad common-law authority to devise any and all equitable remedies for the misconduct of faithless fiduciaries, including expulsion of a member, unless affirmatively barred by the legislature. In other words, because Tzolis was based, in part, on the "absence of any expressed intent on the part of the Legislature to bar [derivative] actions in the context of limited liability companies" (Br. 29) and, in other part, on the court’s recognition of "the importance of courts providing a judicial remedy for a breach of fiduciary duty" (Br. 26),
under Tzolis, a limited liability company must, and does, have the right to expel a dishonest and disloyal member, even in the absence of an operating agreement provision expressly providing for expulsion, lest the courts sanction or condone a "license to steal". [Br. 29]
WC’s brief opposing the appeal (read here) argued that §701’s single reference to expulsion does not authorize judicial expulsion and "simply means that in the event an operating agreement provides for such expulsion, certain events might thereafter occur if a member is actually expelled pursuant to agreement" (Br. 34). In response to the Tzolis argument, WC argued:
The Court in Tzolis merely stated that given the well established history of derivative suits, that particular remedy should be available to LLC members. It never stated that a fortiori other remedies that are not provided for in the LLC Act should be available. [Br. 36]
In his reply brief (read here), MCC pressed his argument for expansive judicial common-law authority to devise equitable remedies to right alleged wrongs, urging the court to apply the reasoning of Tzolis in support of an expulsion remedy for LLC member misconduct. His reply brief also cited Gottlieb v. Northriver Trading Co., LLC, 58 AD3d 550 (1st Dept 2009), which I wrote about here, where a Manhattan appellate panel relied on Tzolis in recognizing an LLC member’s common-law right to an equitable accounting.
The Second Department’s decision earlier this month, rejecting MCC’s appeal, unfortunately does not directly address the Tzolis argument. According to attorney Jeffrey Eilender of Schlam Stone & Dolan LLP, who represented WC and attended the oral argument of the appeal, the panel gave the Tzolis argument a "very frosty" reception. In any event, here’s what the court wrote:
The Supreme Court properly granted that branch of the defendant’s motion which was to dismiss the second cause of action seeking his expulsion as a member of the plaintiff 45-52 Northern Blvd, LLC (hereinafter the LLC). It is undisputed that the default provisions of the Limited Liability Company Law apply, as neither the articles of organization nor the alleged operating agreement of the LLC contain a provision concerning expulsion of members (see Manitaras v Beusman, 56 AD3d 735; Ross v Nelson, 54 AD3d 258). Although Limited Liability Company Law § 701 mentions expulsion of members, there is no statutory provision authorizing the courts to impose such a remedy. Rather, the reference to expulsion of members contemplates the inclusion of such a provision in an operating agreement. As the LLC did not have an operating agreement setting forth a mechanism for the expulsion of members, the plaintiff failed to state a cause of action for this relief.
In a post I wrote over two years ago, spurred by a Utah court decision, I contrasted that state’s LLC Act, which contains express authorization for judicial expulsion of an LLC member whether or not also authorized in the operating agreement, with New York’s LLC Law which has no similar language. The Chiu decision removes any remaining doubt that the sole path to member expulsion for a New York LLC runs through the operating agreement. Does Chiu, on the heels of 1545 Ocean Avenue, also signal a pullback from liberal judicial intervention in the internal affairs of LLC members, effectively forcing the members to live with their agreements for better or worse? My safe answer is, it’s too early to say.
Finally, the question whether it makes good sense to include a member expulsion clause in the operating agreement is an altogether different issue which, coincidentally, I raised in a post last month about a case in which the court upheld an LLC member’s expulsion for cause as specified in the operating agreement.
Ribstein on Tzolis: Professor Larry Ribstein, no fan of the Tzolis decision, comments on Chiu here.
Update March 2, 2012: On February 28, 2012, the Appellate Division, Second Department, issued a pair of decisions in two separate appeals (read here and here) affirming trial court orders denying motions to adjudicate summarily Winston Chiu’s alleged 25% interest in the LLC.