It’s been a rough couple of months for Joseph Sullivan.
First, in May the New York Court of Appeals (the state’s highest court) threw out Sullivan’s claim for wrongful termination of his employment as compliance officer of a hedge fund known as Peconic Partners. The court ruled that Sullivan’s alleged retaliatory firing, for objecting to improper trading by Peconic’s majority owner, William Harnisch, did not fall within any exception to New York’s at-will employment doctrine (read decision here).
Then, last month, an intermediate appellate court threw out Sullivan’s claim that, after Harnisch forced him out of Peconic, he was wrongfully deprived of millions of dollars of profit sharing due him as a minority member of the limited liability company. The decision by the Appellate Division, First Department, which is the focus of this article, disagreed with the trial court’s interpretation of the governing operating agreement and held that the agreement gave the majority member unbridled discretion to allocate certain profit and loss between the members even after the close of the LLC’s fiscal year. Sullivan v. Harnisch, 2012 NY Slip Op 05238 (1st Dept June 28, 2012).
The case involves two New York LLCs, originally known as FLA Asset Management, LLC and FLA Advisors, LLC, that were registered investment advisors and subsidiaries of Forstmann-Leff. From 1999 through 2004, Sullivan served as Chief Financial Officer of the companies in the hedge fund business. Harnisch was Chief Executive Officer and Chief Investment Officer. In late 2004, the companies split off from Forstmann-Leff and were renamed Peconic Partners LLC and Peconic Asset Managers, LLC, with Harnisch and Sullivan as 85% and 15% members, respectively.
The Peconic companies were governed by substantially identical, pre-conversion operating agreements dated January 2003, at which time Harnisch was sole member and the designated sole manager. Section 10(a) of the agreements (read here) provided that 25% of the firms’ net profits and losses were to be allocated among the members in accordance with their ownership percentages, and the remaining 75% based on their “Sharing Ratios for such fiscal year or other period.” The agreements define “Sharing Ratios” in Section 1(z) as:
the percentage, as determined from time to time by the Manager(s), set forth opposite such Member’s name on Schedule I hereto, as amended, modified or supplemented from time to time.
From late 2004 until October 2008, Sullivan served under Harnisch as Chief Operating Officer and Chief Compliance Officer of the Peconic companies. According to Sullivan, in April 2007, as a result of increased profits, Harnisch orally agreed to increase Sullivan’s profit interest from 15% to 33% retroactive to 2006. Sullivan’s subsequently-issued 2006 Form K-1s allocated one-third of the net profits to him.
The Harnisch-Sullivan relationship fractured the following year amidst an extraordinary increase in profits to over $50 million for 2007 and 2008. In mid-September 2008, Harnisch sought Sullivan’s agreement to an amended operating agreement fixing Sullivan’s ownership interest at 15% commencing January 1, 2008, rather than 2004, without any mention of Sullivan’s 33% profit share and including release language that would have extinguished Sullivan’s claimed 33% share of 2007 profits. Sullivan refused to sign.
Later that same month, according to Sullivan, he discovered that Harnisch had engaged in unlawful “front-running” sales of his personal shares ahead of selling client shares. In October 2008, Harnisch allegedly fired Sullivan and terminated his membership interest after Sullivan demanded that Harnisch reverse the challenged sales.
Sullivan thereafter sued Harnisch and the Peconic companies for wrongful termination, breach of the oral agreement for one-third of the profits for the years 2007 and 2008 totaling over $14 million, and other claims. As already noted, Sullivan’s wrongful termination claim met its demise in the Court of Appeals last May.
Meanwhile, in April 2011, Justice Richard Lowe of the Manhattan Commercial Division (subsequently elevated to Presiding Justice of the Appellate Term, First Department) issued a Decision and Order determining the parties’ motions for summary judgment (read here):
- dismissing Sullivan’s claim to enforce the oral agreement giving him 33% of the 2007 and 2008 profits, on the ground that the claim was barred by provisions in the operating agreements prohibiting any oral modification;
- dismissing Harnisch’s defense that as sole manager, he had unfettered discretion under Sections 10(a) and 1(z) of the operating agreements to allocate to Sullivan a zero Sharing Ratio with respect to 75% of the firms’ net profits; and
- declaring Sullivan’s entitlement to 15% of the entirety of the companies’ 2007 and 2008 net profits.
(For anyone interested in more detail concerning the parties’ factual and legal contentions, here are the links to Sullivan’s briefs in support of his own summary judgment motion and in opposition to defendants’ motion, and the defendants’ briefs in support of their own summary judgment motion and in opposition to Sullivan’s motion.)
The First Department’s Ruling
Harnisch and the Peconic companies appealed to the Appellate Division, First Department, which last month unanimously reversed Justice Lowe’s decision and entered an order dismissing Sullivan’s claims seeking a greater share of the 2007 and 2008 profits. (It appears that Sullivan did not pursue, and thus the appellate panel did not consider, any challenge to Justice Lowe’s dismissal of Sullivan’s oral-agreement claim for a 33% profit share.)
The appeal turned mainly on the interpretation of Section 10 of the operating agreement. Sullivan argued, and Justice Lowe had agreed, that once the companies’ fiscal year ended, Harnisch as manager did not have the authority to make any changes to the members’ Sharing Ratio as that term was defined in Section 1(z). The argument was based on Section 10(d) which provided, in pertinent part,
If there is a change in any Member’s Ownership Percentage or Sharing Ratio during any fiscal year or other period of the Company, subsequent allocations of Profits and Losses shall be adjusted in accordance with Section 706 of the [IRS] Code using the closing-of-the-books method . . ..
In other words, as Justice Lowe had written and as Sullivan argued on appeal, “while Harnisch may have had the authority to determine bonus amounts after the expiration of the fiscal year, as may be common practice regarding employees of a firm, a member’s sharing ratio may not be determined retroactively pursuant to [Section 10(d)].”
The appellate panel disagreed, finding that Section 10(d) in no way restricted Harnisch’s sole discretion under Sections 10(a) and 1(z) to determine “from time to time” what portion, if any, of the 75% of net profits to allocate to Sullivan as his Sharing Ratio. Here’s what the court wrote about Section 10(d):
Section 10(d) of the operating agreements . . . cannot, as the motion court found, be reasonably construed to bar all retroactive adjustments of the sharing ratio. Rather, that section merely sets forth how the LLC will allocate profits and losses in the event that a sharing ratio is altered during a fiscal year and there is thus one ratio for the period of the fiscal year before the date of the change and another ratio for the period after that date. It cannot be read to prohibit Harnisch, after a fiscal year is complete, from first deciding retroactively what a member’s sharing ratio will be for that fiscal year, a right that, again, is clear from the definition of the term sharing ratio.
The court likewise rejected Sullivan’s secondary arguments, based on K-1s and other documentary evidence designed to support his claim to at least 15% of the total profits of the companies. The decision minces no words in stating the court’s view, that Sullivan cannot rightfully expect to obtain via judicial remedy benefits that he failed to bargain for:
Even if these documents establish that plaintiff had a sharing ratio of 15% before Harnisch decided on how to distribute the bonus pool for the 2007 fiscal year, they shed no light whatsoever on whether Harnisch had the right to change the sharing ratio, even impetuously and on a retroactive basis. Indeed, the operating agreements allowed Harnisch to alter plaintiff’s sharing ratio as he saw fit. Because plaintiff failed to protect himself in the operating agreements, his bonuses were subject to Harnisch’s whimsy, and the court erred in supplying its own calculation of a sharing ratio for plaintiff (see Greenfield v Philles Records, 98 NY2d 562, 569-570 ) instead of dismissing his breach of contract claim.
Unless you’re a tax lawyer or CPA, it can be very difficult to read much less comprehend the sometimes mind-numbingly complex provisions in an LLC operating agreement dealing with tax issues. Section 10(d) of the Peconic companies’ operating agreements appears to use fairly standard language allowing the manager to make accounting adjustments required by the admission or departure of a member, or an increase or decrease in a member’s ownership percentage, at some interim point during the fiscal year. Sullivan’s interpretation of the provision, as cutting off the manager’s ability to make interim adjustments at any time after the close of the fiscal year, likely would pose practical difficulties inconsistent with the provision’s main purpose.
Update May 19, 2020: The Appellate Division, First Department, issued two recent rulings in cases involving an LLC manager’s sole-discretion authority, in one case affirming an order allowing the plaintiff’s fiduciary breach claim to proceed, and the other affirming the dismissal of the plaintiff’s fiduciary breach claim. Catch up here.