Over the years I’ve seen a boatload of crudely prepared operating agreements for New York limited liability companies. These agreements often derive from generic forms grabbed off the internet, including forms offered by paid services such as LegalZoom, or from recycled, one-size-fits-all forms used by attorneys without paying meaningful attention to the special considerations and needs attendant to the particular business being formed. Once signed, these agreements are locked away and ignored until the outbreak of hostilities among the co-members, at which point they resurface to the great dismay of one or another faction upon realizing that what they signed only provides more fodder for litigation.
The common thread for these newborn LLCs is the inability or unwillingness of the business owners to invest upfront the financial resources needed to secure a customized, well-considered and well-drafted LLC agreement that anticipates and resolves through contractual means the kinds of potential disagreements — over management, finance, compensation, distributions, sale of equity stakes, etc. — that can arise in the life cycle of a multi-member LLC.
That is not to say I haven’t seen excellent, carefully prepared, thorough LLC agreements for New York LLCs. Certainly I have, usually involving more highly capitalized ventures and particularly those structured with both managing and non-managing members. My guess, however, is that such agreements are relatively infrequent given the great preponderance of small, member managed, minimally capitalized companies formed each year in New York as LLCs.
I also suspect they’re relatively infrequent for another reason: Delaware. For a number of reasons, business owners and their transactional advisors favor using a Delaware LLC to form their New York based company when the business has a more complex structure, is highly capitalized, and the managers desire protection against claims by non-manager members afforded by the fiduciary “outs” available under Delaware’s LLC Act. Consequently, at least in my experience, when I encounter an LLC agreement for a New York based Delaware LLC, the agreement is more likely to be a sophisticated, tailored and comprehensive document prepared (presumably) at considerable expense by experienced transactional lawyers at highly capable firms.
When I posed the question to one of my partners, Steve Melore, who regularly prepares LLC agreements as part of his corporate law practice, he also pointed out that if a New York based business is sophisticated enough to even identify the option of forming under Delaware law, then chances are the principals are receiving advice from sophisticated counsel or CPAs more likely to prepare a better agreement.
Does that mean there’s never litigation among members of Delaware LLCs that have sophisticated LLC agreements? Heck no. Courts in Delaware, New York, and many other states that host Delaware LLCs are regularly called upon to adjudicate the internal disputes of Delaware LLC members. However, my impression, for whatever it’s worth and for which I can cite no empirical data, is that, compared to cases involving New York LLCs, a greater proportion of these disputes are summarily determined based on the more carefully prepared language of the LLC agreement. In other words, my hypothesis is that the relatively greater sophistication of Delaware LLC agreements contributes to more expedient adjudication of member disputes and, moreover, likely acts as a deterrent to the cases that we don’t know about because they’re never brought.
The CTNY Case: Waterfall Provision Construed
Two recent decisions by New York courts, involving Delaware LLCs with sophisticated LLC agreements, provide at least some support for my hypothesis.
The first is CTNY Investors 3, LLC v DME CRE Opportunity Fund I LP, 2014 NY Slip Op 30268(U) [Sup Ct NY County Jan. 29, 2014], decided last month by Manhattan Commercial Division Justice Shirley Werner Kornreich. The case involves a dispute between sophisticated real estate investment funds over the proceeds from the development and sale of commercial condominiums at 40 Broad Street in lower Manhattan owned by a Delaware LLC in which the plaintiff and defendant held 5% and 95% membership interests, respectively. The members entered into a carefully prepared, 45-page operating agreement which delegated responsibility for day-to-day management, and for identifying investment opportunities, to the plaintiff in return for payment of a so-called “promote” contingent on the achievement of certain financial milestones.
In November 2013, at which point all the condominium units had been sold, plaintiff filed suit primarily seeking declaratory and injunctive relief to enforce its claimed promote of approximately $840,000. The dispute centered on the distribution “waterfall” provisions set forth in § 6.1 of Article VI of the operating agreement entitled “Distributions of Available Cash.” The two, initial tiers of the waterfall, set forth in § 6.1(a)(i)-(ii), called for pro rata distributions (i.e., 5%/95%) until both members recovered their capital contributions and until defendant achieved a specified internal rate of return. The next three tiers, in subsections (iii) through (v), captured the promote by giving plaintiff escalating percentages from 20% to 25% payable upon defendant achieving escalating internal rates of return and, ultimately, a straight 35%/65% split.
A second, key provision, in § 6.1(c) required, “[n]otwithstanding any contrary term set forth in this Agreement,” that until the defendant recovers 150% of its capital contributions, “100% of all Distributions shall be made to the Members pro rata in accordance with their Percentage Interests, without taking into account the Promote . . .” (emphasis added).
The dispute over the agreement’s interpretation came to a head in the procedural setting of the plaintiff’s motion for a preliminary injunction restraining the defendant from making cash distributions pending the lawsuit. In a nutshell, the plaintiff contended that the promote accrued from “day one,” to be paid out after defendant received 150% of its capital contributions under § 6.1(c), whereas the defendant argued that the promote accrued only when the waterfall reaches subsection (iii) of § 6.1(a). Under the defendant’s interpretation, plaintiff’s promote entitlement was under $20,000.
Justice Kornreich’s decision initially noted that the operating agreement is governed by Delaware law under which “‘traditional contract law principles . . . give great weight to the parties’ objective manifestations of their intent in the written language of their agreement'” and requiring that, “‘[i]f a contract’s meaning is plain and unambiguous, it will be given effect'” (quoting In re BP, Inc. Shareholders Litigation, 789 A.2d 14, 54-55 [Del. Ch. 2001]).
There was no ambiguity in the operating agreement’s waterfall provisions, Justice Kornreich found in denying the plaintiff’s motion for injunctive relief based on the agreement’s “precisely defined” terms governing distributions from available cash. Here’s the relevant portion of her decision:
The Promote is a defined term that relates to a specific category of payment, which is proscribed within the parameters of Section 6. l(a)’s waterfall. Indeed, the very definition of Promote states that it is “determined under Sections 6.1 (a)(iii)-(v).” Thus, as with the other levels of the waterfall, the Promote kicks in when the threshold of the prior level (Section 6.1 (a)(ii)) is satisfied. Nothing in its definition nor elsewhere in the Agreement provides for a special accrual rule for the Promote. As with subsections (i) & (ii), subsections (iii) & (iv) are to be calculated when that level of the waterfall is reached. To wit, given that each level governs the distribution of Available Cash, an amount that will change as each level of the waterfall is paid out, it does not make sense to carve out a piece of the Available Cash payable under subsection (i) & (ii) to be specially held pending payment of the Promote. Each level of the waterfall is precisely defined to account for the parties’ distribution rights. Had the parties intended to apply a special accrual rule to the Promote, they would have explicitly done so.
In a footnote, Justice Kornreich added that carving out the promote from § 6.1(a)(i) & (ii):
would effectively alter the definition of Available Cash, since the Promote, as [plaintiff] understands it, would be excised and de facto escrowed from the Company’s funds before the Available Cash is computed. The parties, if they so desired, could have done this quite easily with minor drafting alterations.
Although decided on a motion for interim relief, and therefore not technically dispositive of the case, as a practical matter the court’s construction of the operating agreement leaves the plaintiff with nowhere to go, other than pursuing its right to seek appellate review.
For those interested in learning more about the CTNY case, click on the following linked documents filed with the court:
- Operating Agreement
- Plaintiff’s Brief in Support of Injunction Motion
- Defendant’s Brief in Opposition to Injunction Motion
The LCM Holding Case: Compulsory Buyback Provision Construed
The second, recent example of a New York court construing a highly sophisticated Delaware LLC agreement comes from LCM Holdings GP, LLC v Imbert, 2014 NY Slip Op 00595 [1st Dept Feb. 4, 2014], in which the Manhattan-based Appellate Division, First Department, reversed a lower court’s decision and summarily granted judgment in the defendant’s favor, declaring that he could not be compelled to sell his 20% membership interest to the company under the “plain language of the agreement.”
The case involves a Delaware LLC that controls a securities broker-dealer of which the defendant Imbert was its CEO and one of three managers before the other two managers terminated him for an alleged act of theft or fraud involving tax refunds. The company’s lawsuit against Imbert, among other claims, sought a declaration that Imbert was required to tender his membership shares upon his termination pursuant to § 10.03 of the governing, 44-page LLC agreement which provided:
In the event that the employment of a Member other than a Manager with the Company or one of its Affiliates is terminated for any reason, such Member shall immediately offer to Transfer all of his Membership Shares in accordance with Section 10.05 [providing, in the event the parties cannot agree on price, for a “conclusive” valuation by “two independent consultants selected by the Board” under § 10.10] [emphasis added].
In the lower court proceedings, the company contended that, upon Imbert’s termination and his subsequent written resignation “from all positions” with the company, he no longer was a manager and therefore was obligated to offer his shares for transfer to the company under § 10.03. Imbert, who claimed his shares are worth at least $15 million, countered that, by its plain terms, § 10.03 was inapplicable because he was a manager at the time of his termination.
In October 2012, the lower court issued a bench ruling denying Imbert’s motion to dismiss the company’s claim seeking a declaration that Imbert was required to tender his shares under § 10.03. The court, picking up a comment by company counsel at oral argument, observed that the LLC agreement was “not a work of art” and found that there were factual issues requiring discovery as to the effect of Imbert’s removal on any obligation to redeem his membership interest.
Work of art or not, the appellate court granting Imbert’s subsequent appeal viewed the “plain language” of § 10.03 as “inapplicable” to Imbert. The court’s discussion of the point, citing Delaware law, follows:
The parties’ rights vis a vis each other as members of a Delaware LLC are defined by the operating agreement (Elf Atochem N. Am., Inc. v Jaffari, 727 A2d 286, 291 [Del 1999]). Here, the agreement lacks any indication that plaintiffs could compel the sale of defendant’s membership interests. Defendant was a manager and an employee of plaintiffs. Plaintiffs rely on section 10.03 of the agreement which allows them to compel the sale of the membership interest upon the termination of the employment of “an employee other than a Manager” (emphasis added). It is undisputed that defendant was a manager at the time of his termination. Thus, under the plain language of the agreement, 10.03 is inapplicable to defendant (see Playtex FP, Inc. v Columbia Cas. Co., 622 A2d 1074, 1076 [Del Super 1992]). Moreover, plaintiffs’ reading deprives the phrase “other than a Manager” of any effect, a result that is contrary to Delaware law (Elliott Assocs., L.P. v Avatex Corp., 715 A2d 843, 854 [Del 1998] [law favors interpretation that gives effect to all terms of contract]).
Subject to any further appellate review by the Court of Appeals, the Appellate Division’s ruling leaves Imbert free to retain his membership interest during his lifetime, and perhaps longer since, under § 10.02(c) of the LLC agreement, the estate of a deceased manager is under no compulsion to sell the decedent’s membership shares.
For those interested in learning more about the LCM Holding case, click on the following linked documents filed with the lower court: