A limited liability company named Ocelot Capital Management, LLC made some new law last month on a narrow but interesting issue: Can the majority member of a manager-managed New York LLC bring a derivative action on its behalf when the manager position is vacant, without alleging either a prior demand upon the manager or that such demand would be futile?

The question drew a negative answer from New York County Commercial Division Justice Bernard J. Fried, who consequently dismissed the derivative claims in Eldan-Tech, Inc. v. Ocelot Capital Management, LLC, Memorandum Decision, Index No. 651101/10 (Sup Ct NY County Oct. 29, 2010).

The dispute in Ocelot begins with a $350,000 promissory note made by Isaac Hershkovitz in favor of Ocelot Portfolio Holdings, LLC (“OPH”) given in partial payment for Hershkovitz’s purchase from Holdings of the latter’s ownership interest in another real estate holding company known as OCG VI.  According to its operating agreement, OPH is a manager-managed LLC whose membership interests are held 80% by plaintiff Eldan-Tech, Inc. (“Eldan”) and 20% by defendant Ocelot Capital Management, LLC (“OCM”).  OCM, which was OPH’s sole manager, is wholly owned by Rachel Arfa and her husband.  At that time Arfa also was the sole officer and director of Eldan.

The day after the note was made, Arfa as manager of OCM and as sole officer and director of Eldan caused OPH to assign the note to OCM.  Several months later, Arfa was removed as an officer and director of Eldan, and OCM was removed as the manager of OPH.

Eldan as 80% member of OPH subsequently filed a complaint asserting a pair of derivative claims on OPH’s behalf alleging that Arfa wrongfully caused the sale of OCG VI from OPH to Hershkovitz and “pocketed the proceeds” by assigning the note to OCM and later recovering a judgment on the note in OCM’s favor.  (Read the complaint here.)

OCM moved to dismiss the complaint on the ground Eldan lacks standing to assert derivative claims because its complaint fails to plead that a prior demand was made on OPH’s “board” or that such demand would be futile.  OCM contended that under OPH’s operating agreement, Eldan had unfettered authority both to remove and to appoint the manager of OPH, hence nothing prevented Eldan from causing OPH to bring an action against OCM in OPH’s own name.  OCM further suggested that Eldan, a company based in Israel, deliberately chose not to appoint a new manager for OPH because none of its representatives wished to take on the fiduciary duties attendant to the position or to submit themselves to personal jurisdiction in New York.  (Read OCM’s opening and reply memoranda of law here and here.)

In opposing the motion, Eldan argued that the demand requirement for derivative actions on behalf of LLCs applies only to minority members, and not to a majority member such as itself.  Eldan described the New York Court of Appeals’ 2008 decision in Tzolis v. Wolff, which recognized a common law right to sue derivatively on behalf of an LLC (read here my post on Tzolis), as creating a “permissive” right to sue derivatively but not “requiring” a majority member “to file suits individually.”  Eldan also contended that it was unable to make a demand because the person it appointed to replace OCM as manager resigned from the position several months later.  (Read Eldan’s opposition brief here.)

Justice Fried’s legal analysis cites post-Tzolis cases, including Evans v. Perl, 19 Misc3d 1119(A) (Sup Ct NY County 2008), and Billings v. Bridgepoint Partners, LLC, 21 Misc3d 535 (Sup Ct Erie County 2008), in which the courts held that the long-established demand requirements for statutory derivative actions involving corporations also apply to LLC common law derivative actions.  (Read here my post on the Evans and Billings cases.)  Eldan’s complaint, he continues, fails to comply with this rule in that it alleges neither the making of a demand nor that doing so would have been futile.  So while Eldan is correct that Tzolis allows Eldan to bring a derivative action, “the demand requirement still must be met.”  The fact that OPH has no manager, Justice Fried adds, does not permit Eldan as majority member to act on OPH’s behalf when OPH, as provided in its operating agreement, “is a manager-managed as opposed to member-managed LLC, and such conduct by Eldan would be contrary to that Agreement.”  The court accordingly concludes that Eldan “lacks standing to bring a derivative claim on behalf of OPH.”

I can imagine circumstances where, due to disproportionate allocation of voting power or a super-majority voting requirement in the operating agreement, a majority member of a manager-managed LLC might have to bring a derivative action. But even so, I can’t think of a logical reason for an exemption from the demand requirements which are founded on the notion that the decision to bring suit belongs to the company through its governing body.

Update December 8, 2011:  The Appellate Division, First Department, today denied Eldan’s appeal from Justice Fried’s ruling, stating that Eldan’s “argument that the demand requirement was inapplicable because it had a majority equity interest in OPH, as opposed to a minority interest, is unavailing. BCL 626(c) does not differentiate between minority and majority shareholders for demand purposes. Moreover, the enumerated exceptions to the demand requirement have not been shown to be applicable here.” The appellate decision is reported at 2011 NY Slip Op 08830.