Two years ago, I blogged about a decision in a case called Stulman v. John Dory LLC which, as far as I knew at the time, was the sole decision by a New York court in which a dissenting member of a limited liability company (LLC) sought to block an allegedly unlawful freeze-out merger. The court gave the merger a green light after finding that the ousted minority member in a restaurant business failed to establish that the merger was procedurally improper or “tainted with fraud, illegality, or self dealing.”
Since Stulman, there was one other reported New York case that I blogged about last year involving an LLC freeze-out merger, Alf Naman Real Estate Advisors, LLC v. Capsag Harbor Management, LLC, but that case focused almost entirely on the minority member’s challenge to the offered price for his membership interest and only peripherally on the merger’s technical compliance with the operating agreement, i.e., there was no claim of underlying fraud or misconduct.
Recently I came across a third, new decision in an LLC merger case more akin to Stulman, in which Manhattan Commercial Division Justice Melvin L. Schweitzer examined a disputed LLC freeze-out merger involving a realty management company. Unlike in Stulman, Justice Schweitzer’s decision in SBE Wall, LLC v. New 44 Wall Street, LLC, 2013 NY Slip Op 32104(U) (Sup Ct NY County Aug. 29, 2013), found that the dissenting plaintiffs’ allegations of misconduct by the controlling member, including misrepresentation, concealment, and use of a pretextual capital call in furtherance of a “sham” merger to deprive plaintiffs of their equity stake, fell within an exception to the LLC Law’s provision mandating appraisal as the dissenting members’ exclusive remedy, and enabled them to proceed with their claims seeking to invalidate and set aside the merger.
The combination of Stulman and SBE Wall raise an interesting question about the interplay of the LLC Law’s two, separate provisions that address the dissenting member’s exclusive appraisal remedy. But first let’s look at what happened in SBE Wall.
The Freeze-Out Merger in SBE Wall
According to the complaint (read here), SBE 44 Wall, LLC (“Wall”) was formed as a New York LLC in 2003 to operate a number of office buildings in lower Manhattan. The two plaintiff entities collectively invested $7.8 million in return for a 21.8% membership interest, with the remaining 78.2% interest held by an entity abbreviated as KFS which owned some or all of the managed buildings. In 2009, as part of a prior litigation settlement, the plaintiffs agreed to appoint KFS as Wall’s sole manager.
The seeds of the current litigation were planted in late 2011, when KFS made a capital call allegedly in violation of the operating agreement and without any legitimate business purpose. KFS also allegedly failed to provide plaintiffs with documentation required by the operating agreement in connection with the capital call.
In July 2012, by written consent without a meeting, KFS approved and entered into a merger agreement between Wall and New 44 Wall Street, LLC (“New Wall”), a company wholly owned by KFS, with New Wall as the sole surviving company. The written consent cited the need “to raise equity capital to continue its existence” as reason for the merger. Under the terms of the merger agreement, the plaintiffs were required to surrender their membership interests for “fair value” offered in the amount of “zero.” Plaintiffs rejected the offer.
In August 2012, New Wall filed a petition against the minority members for an appraisal of the fair value of their interests (read here). In November 2012, the minority members started a separate action with a complaint attacking the merger’s bona fides and seeking to enjoin it. The minority members subsequently secured an order from Justice Schweitzer (read here) staying the appraisal proceeding pending determination of their injunction action.
Meanwhile, KFS moved to dismiss the injunction action on several grounds. First, it argued that the injunction action was precluded by the appraisal proceeding under the “prior action pending” rule. Second, KFS argued that “undisputed” documentary evidence, including the “independent appraisal” performed to value the plaintiffs’ interests, established the complaint’s lack of merit. Third, KFS argued that the complaint failed to allege the essential elements of a claim for fraud. (Read here KFS’s brief in support of its dismissal motion.)
In opposition, the plaintiffs described KFS’s appraisal proceeding as “maliciously conceived” and argued that it did not preclude an action to set aside the merger. Plaintiffs also argued that the complaint adequately alleged grounds to conclude that the merger was the product of a fraudulent or unlawful scheme to deprive plaintiffs of the value of their interest in Wall. (Read here the plaintiffs’ brief opposing the dismissal motion.)
Justice Schweitzer’s Ruling
In his decision last August, Justice Schweitzer one-by-one rejected each of KFS’s arguments for dismissal:
- The appraisal proceeding and the injunction action are not duplicative and the former therefore does not preclude the latter (Decision pp. 3-6).
- The documentary evidence relied on by KFS, including the appraisal it obtained of Wall, fails to “conclusively establish that plaintiffs do not have any viable claims” (Decision pp. 6-9).
- The complaint pleads sufficient details for a cause of action for fraud, including the alleged misrepresentation by KFS that it “would manage 44 Wall for the benefit of its members consistent with the Operating Agreement”; KFS’s alleged concealment of its intention to cause a freeze-out merger and deprive plaintiffs of their ownership interest in the company, and its use of a capital call as a sham pretext for the merger; and KFS’s use of its manager position to withhold facts of its scheme to create a sham merger (Decision pp. 9-12).
- The plaintiffs’ claims other than fraud are properly pleaded as individual, direct claims and are not derivative as contended by KFS (Decision pp. 12-14).
There’s been no reported activity in the case since the decision, other than an impending change of plaintiffs’ counsel.
Do Stulman and SBE Wall Properly Conceive the Exceptions to the Exclusive Appraisal Remedy in LLC Mergers?
When the LLC Law was enacted in 1994, legislators borrowed almost verbatim the provision in § 121-1102(d) of New York’s Revised Limited Partnership Act (RLPA) establishing appraisal as the exclusive remedy for a limited partner who dissents from a merger, subject to certain narrow exceptions based on noncompliance with the partnership agreement or with notice and voting requirements. The borrowed language appears in LLC Law § 1002(g), as follows:
A member of a domestic limited liability company who has a right under this chapter to demand payment for his or her membership interest shall not have any right at law or in equity under this chapter to attack the validity of the merger or consolidation or to have the merger or consolidation set aside or rescinded, except in an action or contest with respect to compliance with the provisions of the operating agreement or [the notice and voting provisions in] subdivision (c) of this section.
Fast forward to 2008, when New York’s highest court construed RLPA § 121-1102(d) in Appleton Acquisition, LLC v. National Housing Partnership, 10 NY3d 250 (2008). The court in Appleton held that § 121-1102(d) bars a limited partner from bringing an action to invalidate a merger or even seeking damages based on allegations of fraudulent or illegal acts by the managing general partner, and that the statutory appraisal proceeding is the exclusive remedy for such claims. As stated in Appleton’ s majority opinion,
This language reveals a directive by the Legislature to make an appraisal proceeding the “sole remedy of a limited partner to attack the validity of a merger” (Rich, Practice Commentaries, McKinney’s Cons Laws of NY, Book 38, Partnership Law art 8-A, 2008 Pocket Part, at 61).
The Appleton opinion also contrasted RLPA § 121-1102(d) with the exception to the exclusive appraisal remedy found in the analogous dissenting shareholder provision in § 623(k) of the Business Corporation Law (BCL). The latter statute, enacted long before the RLPA, codifies a broader common-law exception by expressly recognizing that a dissenting shareholder may bring an action for equitable relief to set aside a merger that “will be or is unlawful or fraudulent.” The court found dispositive the “intentional legislative omission” of a similar exception in RLPA § 121-1102(d). (Read here my post about the Appleton case.)
One might assume that Appleton‘s narrow construction of the exceptions to RLPA § 121-1102(d)’s exclusive appraisal remedy would carry over in the LLC merger context, since that statute and LLC Law § 1002(g) essentially are clones. But interestingly, in both the Stulman and SBE Wall cases, neither of which cited Appleton, the courts analyzed the plaintiffs’ claims to set aside LLC mergers under the broader exception for fraud and illegality set forth in BCL § 623(k). That’s because, as noted in Stulman, LLC Law § 1002(g) is not the only provision in the LLC Law that implicates a dissenting member’s remedies. There’s also LLC Law § 1005(b), which provides that in cases where the dissenting member and the post-merger LLC can’t or won’t come to agreement on the LLC’s cash offer, “the procedure provided for” in BCL § 623(k) — along with three other specified subdivisions of § 623 — “shall apply.” As noted above, BCL § 623(k) creates an exception to the exclusive appraisal remedy for an “unlawful or fraudulent” merger.
Indeed, this appears to be the only reason the courts in Stulman and SBE Wall assessed the adequacy of the complaints’ allegations of fraud or other illegality in determining whether to apply the exclusive appraisal remedy. But should they have done so in light of Appleton? Keep in mind, just as LLC Law § 1002(g) is a clone of RLPA § 121-1102(d), so too LLC Law § 1005(b) is a clone of RLPA § 121-1105(b). The Appleton opinion specifically cited RLPA § 121-1105(b) for the proposition that “[t]he appraisal procedures for limited partnerships are incorporated from the Business Corporation Law” and, in footnote 4, stated that the appraisal procedures “utilized in these proceedings are delineated in Business Corporation Law § 623(h)-(k)” (emphasis added).
In other words, in Appleton, construing essentially the identical legislative scheme as is found in the LLC Law, the court held that RLPA § 121-1102(d) bars an action to set aside a merger relying on alleged fraud or other unlawful conduct, notwithstanding RLPA § 121-1105(b)’s explicit incorporation of “the procedures” in BCL § 623(k). Moreover, as I mentioned above, the Appleton court put an exclamation point on its holding by finding an “intentional” omission when the legislature left out of RLPA § 121-1102(d) the exception for fraud or illegality found in BCL § 623(k).
I have no interest in the Stulman or SBE Wall cases as a lawyer on behalf of any client. I am not advocating that the courts in either case got it right or wrong. I offer the above observations as food for thought only, with the hope that it might spark some interest or comments from other practitioners.