For the past ten years, a chain of walk-in airport spas called XpresSpa has offered soothing massage and a range of other personal care services to stressed-out air travelers. Now it’s the company’s principals who could use some stress relief following a court decision earlier this month holding that a restructuring involving a capital infusion by a private equity firm unintentionally triggered dissolution of XpresSpa’s parent company under a provision in its operating agreement. The parent company must now prepare for a painful unwinding and liquidation at the direction of a court-appointed receiver.
The decision by Manhattan Commercial Division Justice Melvin L. Schweitzer in JPS Partners v Binn, 2014 NY Slip Op 31204(U) [Sup Ct, NY County May 6, 2014], came at the behest of a 1.93% investor in the parent company, a New York limited liability company known as Binn and Partners, LLC, controlled by its sole managing member, Moreton Binn. The dissident member, apparently alone among the company’s investors, refused to consent to the proposed restructuring. Mr. Binn nonetheless proceeded with the transaction after amending the LLC’s operating agreement in a manner designed to blunt the dissenting member’s objection. Justice Schweitzer found that the amendment exceeded Mr. Binn’s authority and that the restructuring constituted a transfer of the LLC’s assets within the meaning of the operating agreement’s provision requiring dissolution upon “the Transfer of substantially all of the assets of the Company.”
Assuming the decision stands — Mr. Binn and the LLC have filed a notice of appeal — the court’s ruling offers an important lesson about drafting dissolution provisions in LLC operating agreements so as not to empower passive minority investors in start-up companies from interfering with growth opportunities requiring new sources of capital.
Binn and Partners, LLC (the “LLC”) was founded in 2000 and opened its first airport spa in 2004. Over the next ten years it expanded to over 45 XpresSpa locations in 20 airports in the U.S. and abroad. The LLC, which operated the spas through wholly-owned subsidiaries, was owned 55% by Mr. Binn and his wife, and 45% by ten other investors including the plaintiff in the case, JPS Partners (“JPS”), which invested about $500,000.
By 2011, the LLC reportedly required additional capital to maintain its credit facility and to continue its expansion plans. In early 2012, Mr. Binn announced a proposed $23 million investment by a private equity firm called Mistral Capital Management (“Mistral”) in exchange for a 42% interest in the business, further stating that the funds would be used to reduce company debt and to finance expansion plans. The letter announcing the proposal (read here) requested that each member sign an enclosed form of Unanimous Written Consent approving a two-step transaction:
- first, the LLC will contribute its entire interest in the operating subsidiaries to a newly formed Delaware LLC (“New XpresSpa”) which initially will be a wholly-owned subsidiary of the LLC, then
- Mistral will acquire a 42% managing membership interest in New XpresSpa for $23 million.
JPS alone among the minority members objected to the proposed transaction (which it claimed constituted an event of dissolution under the LLC’s operating agreement), refused to sign the consent, and offered without success to sell its 1.93% interest back to the LLC. Notwithstanding, Mr. Binn and the other investors voted to approve and consummate the transaction. Before doing so, however, Mr. Binn employed his express authority as sole manager to amend the LLC’s operating agreement to approve an amendment to the agreement’s article governing dissolution, in effect providing that the LLC would continue in existence so long as it held its interests in the restructured business (read here).
Shortly before the LLC and Mistral closed the transaction, JPS filed suit and sought an interim injunction to prevent the members from holding a vote, which Justice Schweitzer denied. After the deal closed, in July 2012 JPS filed an amended complaint seeking dissolution and asserting numerous other claims against Mr. Binn (read here).
The defendants filed a motion to dismiss the amended complaint. In his April 2013 decision (read here), Justice Schweitzer granted the motion in part but left standing most of JPS’ claims, including its claim under LLC Law § 701(a)(2) seeking to dissolve the LLC on the ground that the transfer of its assets to New XpresSpa triggered dissolution under the operating agreement’s express terms.
JPS’ Summary Judgment Motion
In November 2013, JPS moved for partial summary judgment on its claim to dissolve the LLC and to appoint a receiver to wind up its affairs. In its supporting brief (read here), JPS contended that the LLC’s assignment of its interests in the operating subsidiaries to New XpresSpa was a transfer of substantially all of the LLC’s assets, thereby triggering dissolution within the meaning of § 8.01(b) of the operating agreement (read here) stating that:
The Company shall . . . be dissolved upon the occurrence of . . . [t]he Transfer of substantially all of the assets of the Company.
JPS also argued that the operating agreement made no exception for asset transfers to a subsidiary, and that Mr. Binn’s eleventh-hour amendment of the operating agreement to avoid dissolution was ineffective under § 9.07 of the operating agreement, which required the consent of any member adversely affected by a change to specified articles of the operating agreement including Article VIII governing dissolution.
In their opposing memorandum (read here), Mr. Binn and the LLC argued that the transfer of the LLC’s assets to its subsidiary did not trigger dissolution; that even if § 8.01(b) of the operating agreement was ambiguous, parol evidence showed that the operating agreement did not contemplate dissolution without a liquidity-generating event; and that even if the transfer did constitute an event of dissolution, the amendment to the operating agreement authorized by Mr. Binn, permitting the LLC to continue its operations, did not adversely affect JPS and therefore did not require its consent.
Justice Schweitzer’s Decision
In his decision earlier this month, Justice Schweitzer found that the transfer of substantially all the LLC’s assets to New XpresSpa triggered dissolution under the “clear and unambiguous” language of § 8.01(b) of the operating agreement. The fact that the transfer was made to a subsidiary, and that it was not a liquidity-generating event, did not even register in the court’s decision.
Justice Schweitzer likewise gave no weight to the defendants’ reliance on the amendment to the operating agreement, finding that the amendment “constitutes a material adverse limitation on [JPS’] right to dissolution” and therefore required its consent. As he explained:
JPS alleges that the amendment to the Operating Agreement adversely affected its rights to dissolution in the event of a transfer of substantially all of the assets of [the LLC], and that its written consent was not obtained in connection with adopting this amendment. Defendants counter that at the time of the amendment, consent was not required because the amendment did not adversely affect JPS, and JPS had no right to dissolution. This argument is wrong, as well as beside the point. Under Section 9.07, consent is required if the amendment would vary the terms of dissolution, which there is no question it does here; prior to the amendment a transfer of substantially all of [the LLC’s] assets would have triggered dissolution, but after the amendment [the LLC] would not be dissolved if it retained any illiquid assets, such as membership interests in a non-public company. The evidence shows that the amendment was crafted to cover the transaction at issue, which resulted in [the LLC] holding a 55% membership interest in [New XpresSpa]. But there is no getting around the fact that substantially all of [the LLC’s] assets were transferred to accomplish this result. The fact that the Binn defendants are relying on the amendment to shield [the LLC] from dissolution is evidence alone of its adverse impact on JPS.
The court’s order appoints a receiver “for the purpose of unwinding the business of Binn and Partners, LLC, liquidation, and recovery of assets,” and gives the receiver authority to engage an attorney, an accountant and any other professionals needed to perform the receiver’s duties. As noted above, counsel for Mr. Binn and the LLC promptly filed a notice of appeal, perhaps presaging an application for an interim stay of the trial court’s order pending appeal.
- Hindsight makes it easy to criticize the operating agreement in this case for including as an event of dissolution a transfer of substantially all of the LLC’s assets, or doing so without expressly differentiating between (a) liquidity and non-liquidity generating transactions and (b) third-party and related-party transfers. I’ve seen similar, unqualified provisions in operating agreements of real estate holding companies, but rarely with operating companies and even less so with early-stage companies whose business plan, as in this case, depends on aggressive, capital-intensive growth. There was nothing esoteric or unforeseeable about the structuring of the private equity capital raise for the XpresSpa business. The dissolution provision ultimately gave extraordinarily disproportionate bargaining power to a member holding less than 2% of the company’s equity.
- As defendants noted in their memorandum of law, just about all the case law addressing whether a transaction constitutes a transfer of substantially all of the assets of an entity arises in the context of minority shareholders claiming the right to dissent and be bought out for fair value under §§ 909 and 910 of the Business Corporation Law. The default rule in § 402(d)(2) of the LLC Law uses the same language in requiring majority approval by the members for a sale of substantially all of the LLC’s assets, but the LLC Law does not give members a right analogous to that possessed by corporation shareholders to dissent from such a transaction and be bought out for fair value. In other words, had the LLC in the JPS case not included a dissolution provision triggered by an asset transfer, the minority member would not have been able to cash out as a dissenting member, raising anew the question, what salutary purpose was served by including the fatal dissolution provision?
- My corporate partner Alon Kapen, who advises emerging companies and venture capital clients and who also publishes the New York Venture Hub blog, shared the following comment about the case:
Inasmuch as JPS v Binn turns entirely on the unique provisions of the company’s operating agreement and not on the terms of the proposed transaction, the case underscores the importance for a private equity investor to perform exhaustive due diligence on the target company’s constituent documents to identify potential impediments to the deal. From a practical standpoint, it’s also unclear why Binn and/or Mistral did not elect to accept JPS’ offer and use part of the $23 million in the deal to buy out JPS’ 1.93% interest. Liquidity for its equity seems to be JPS’ real objective here, with dissolution simply a means to the end in the absence of a buyout.
Update July 15, 2014: It appears that I correctly predicted an appellate stay application, which was denied by the Appellate Division, First Department, on June 19, 2014 (see order here).