The contractarian recoils at the notion of equitable remedies in LLC dissolution cases. Allowing judges to grant relief ex post facto based on principles of equity untethered to the parties’s operating agreement, the contractarian argument goes, erodes the contract-based nature of the LLC — that which makes LLCs fundamentally different from corporations — and breeds moral hazard by rescuing LLC members from their shortsighted failure to bargain for desired rights and remedies in the LLC agreement.

One would be hard pressed to find a more powerful rejoinder to the contractarian argument than the case of Mizrahi v. Cohen, 2013 NY Slip Op 50092(U) (Sup Ct Kings County Jan. 15, 2013), decided last month by Brooklyn Commercial Division Justice Carolyn E. Demarest (pictured). What’s more, Justice Demarest’s opinion, in which she ordered a Lyons-style auction sale of LLC membership interests (I’ll explain below), is refreshingly candid about the court’s necessary employment of its equitable powers to avoid the glaring injustice that would have resulted in Mizrahi had the court stayed within the strict confines of the LLC agreement.

Mizrahi may sound familiar to regular readers of this blog. About a year ago I wrote about Justice Demarest’s prior decision in the case (read here) ordering dissolution of an LLC co-owned 50/50 by brothers-in-law. The LLC was formed to own, renovate and operate a small commercial building in Brooklyn used by the two members for their separate dental and optometry practices and to rent additional space to third-party tenants. Justice Demarest dissolved the LLC on the ground that continuing it was financially unfeasible due to the defendant member’s failure to provide needed financial support and his undermining of the LLC’s financial integrity by withholding rent and taking unauthorized cash withdrawals.

Justice Demarest’s decision last year stopped short of ordering the winding up and liquidation of the LLC pending an accounting by the LLC’s accountant and an appraisal of the LLC’s realty by an independent appraiser. At that time she also rejected the plaintiff’s suggestion that the court allocate him a greater than 50% interest in the LLC proportional to his greater capital contributions, and that he be permitted to purchase the defendant’s diminished interest.

Her decision last month reported the results of the accounting and the appraisal. The accounting concluded that the plaintiff and defendant had capital accounts of approximately $1.2 million and $300,000, respectively, and that the defendant owed rent arrears of about $50,000. The property appraisal came in around $4.5 million. Assuming the property were sold for its appraised value, the liquidation of the LLC would result in a net loss of over $1 million due primarily to the mortgage debt of around $4.4 million plus the debt obligation to the plaintiff for his disproportionate contributions.

As bluntly summed up by Justice Demarest, “the LLC is essentially bankrupt” and, upon a liquidation sale of the LLC’s assets, “[b]oth members of the LLC would lose their entire investment.” As she further explained,

It is clear that neither member will be entitled to a “distribution” of assets upon liquidation after satisfaction of the mortgage and payment of other outstanding debts, although plaintiff Mizrahi will be entitled to the repayment of funds he has advanced as a loan if any assets remain after satisfaction of all other obligations. Upon sale of the building to a third party, neither member will be entitled to remain in his commercial unit unless a lease is negotiated with the new owner. Although the Court has hoped and believed that the parties would seek to avoid such Draconian consequences and work out a reasonable solution between themselves, and plaintiff has proposed to lease to defendant his existing premises upon his buyout of [defendant] Cohen’s interest, Cohen has declined and insists upon a public auction and sale.

The plaintiff renewed his request that the court permit him to buy out defendant’s interest in the LLC, based upon the realty’s appraised value, in proportion to the defendant’s lesser capital account. The defendant objected and insisted upon a sale of the realty at public auction and the appointment of a receiver.

Justice Demarest would do neither. The defendant’s insistence on a public auction sale of the realty would leave both members empty handed and ignored the fact that plaintiff, as holder of four times the equity in the LLC as possessed by defendant, had the greatest interest in preserving the LLC’s assets. As for plaintiff’s proposed solution, the parties’s LLC agreement included no provision for a buy-out of a member’s interest by other members upon winding up following dissolution. Nor did it have any provision for reduction or forced sale of a member’s interest upon failure to make a required capital contribution.  “The Operating Agreement,” Justice Demarest commented, “does not . . . expressly authorize the relief plaintiff seeks in the context of a judicial dissolution.” Under such circumstances, she added, “when provisions regarding management and operation are arbitrarily or carelessly adopted, without consideration to future potential problems, the parties may be forced to accept consequences that none of them wanted or intended.”

But a remedy must be devised or, as Justice Demarest put it, “having determined that the LLC should be dissolved, it is the duty of the Court to provide a mechanism for the liquidation and distribution of its assets.” In Mizrahi, she continued, “the inequity of the present situation is profound and warrants Court intervention” based on the unjust enrichment of defendant stemming from his ongoing failure to pay rent to the detriment of plaintiff who “continues to cover all expenses of the building with infusions of additional contributions.”

The winding up and liquidation mechanism selected by the court thus derives not from the LLC agreement but from the court’s “discretion to exercise principles of equity” for which Justice Demarest found support in Lyons v. Salamone, 32 AD3d 757 (1st Dept 2006). In Lyons, the Appellate Division, First Department, held that the absence of a provision in the LLC Law expressly authorizing a buy-out in a dissolution proceeding does not preclude a trial court from granting the parties “mutual buy-out rights,” and that “it is an equitable method of liquidation to allow either party to bid the fair market value of the other party’s interest in the business, with the receiver directed to accept the highest legitimate bid.”

Justice Demarest’s ruling lays out in detail the procedure for a mutual buy-out auction sale of the membership interests, the key features of which are:

• appointment of a liquidation trustee;
• an updated accounting by the LLC’s regular accountant;
• turnover by the parties to the trustee and accountant of all company books and records;
• each member may submit to the trustee a bid for the purchase of the other member’s interest, including the satisfaction of the existing mortgage or, with the mortgagee’s  consent, the assumption of the mortgage and release of the other member as guarantor;
• each bidder must submit a 25% deposit with his bid together with payment of any debt owed to the LLC, however the member shall be given a credit against such deposit for any debt owed to him personally by the LLC;
• the trustee shall accept the highest qualifying bid;
• if no qualifying bid is received, the trustee shall advertise the public auction sale of the property to be sold subject to the mortgage.

Under the outlined procedure, and based on the large debt owed by the LLC to plaintiff and the debt for interest and rent arrears owed to the LLC by defendant, it seems more than likely that the plaintiff will be in a far superior position to put in the winning bid, and that the defendant will be lucky to walk away with a release from personal liability on the mortgage debt.

Justice Demarest rightly calls Mizrahi a “cautionary tale regarding the drafting and execution of the operating agreement” which she describes as a “cut and paste” job summarily executed by the parties without reviewing it immediately before closing on the building purchase in response to the mortgagee’s demands. The parties certainly can be faulted for not anticipating future capital needs for building renovation and operating expense, and for failing to include in their agreement provisions for mandating contributions and spelling out the consequences for failure to contribute. Perhaps the family connection between the plaintiff and defendant is responsible for the inattention to a properly prepared LLC agreement.

But wherever the fault lies, it remains very hard to accept as the “right” result in Mizrahi, simply because the LLC agreement and statute provide no other express solution, a public auction sale of the LLC’s building in which the value of both members’ investment is wiped out entirely, and especially that of the plaintiff who single-handedly carried the building financially for many years. I for one would hate to think that our courts are powerless to provide an equitable remedy under such circumstances.

Update April 1, 2013: On March 27, 2013, after granting a stay of the January 2013 order discussed above, the Appellate Division, Second Department, modified Justice Demarest’s January 2012 order and directed a buy-out of Cohen’s membership interest by Mizrahi. Read my post about the Second Department’s ruling here.