It’s not that I get nostalgic about derivative lawsuits (or Oldsmobiles), it’s just that it feels like we’re in a brave new world when it comes to adapting hoary corporate doctrine to that unincorporated upstart known as the limited liability company.
The clash between old and new looms in a derivative action concerning an LLC pending before Erie County Commercial Division Presiding Justice Timothy J. Walker called Univest I Corp. v Skydeck Corp., Index No. 2014-811644. The case stems from a dispute between the 50% managing member (BDC) and 50% non-managing member (Univest) of 470 Pearl Street, LLC, which was formed in 2004 for the purpose of acquiring for future development a parking lot in Buffalo, New York. Pending the development, BDC and Univest agreed to lease the parking lot to a BDC affiliate known as Skydeck Corp. The lease granted 470 Pearl the right to terminate the lease on 60-days notice.
In 2014, Univest, acting in 470 Pearl’s name, issued a termination notice to Skydeck under authority of an unusual provision in 470 Pearl’s operating agreement that gave either member the unilateral right “to cause 470 Pearl to terminate” the Skydeck lease. Two lawsuits followed Skydeck’s refusal to vacate. In the first, Justice Walker granted Univest a declaratory judgment upholding its termination notice and ordering Skydeck, pending further order, to pay an increased monthly rent (read amended complaint here and the court’s order here).
Shortly afterward, Univest commenced a derivative summary eviction proceeding on behalf of 470 Pearl, naming both Skydeck and BDC as respondents (read petition here). Now, let me pause the story for a moment. I’m not a landlord-tenant lawyer. If you’d asked me, before I looked into the Univest case, whether a non-controlling, non-managing corporation shareholder or LLC member could bring an eviction proceeding against the corporation’s or LLC’s tenant, I’m sure I would have guessed “no” for at least two reasons. First, I would have assumed the governing statute in Article 7 of the Real Property Actions and Proceedings Law somehow limits standing to seek relief to the owner or its authorized agent. Second, evicting a third-party tenant strikes me as quintessential management action. Imagine the chaos if any minority owner of a real estate operating company could take it upon themselves to launch eviction proceedings. But I would have guessed wrong. Gorbrook Associates, Inc. v Silverstein, 40 Misc 3d 425 [Dist. Ct. Nassau County 2013], a case of apparent first impression, held that a non-controlling, minority shareholder may bring derivatively an eviction proceeding.
Back to the story. BDC moved to dismiss the petition on the ground, among others, that Univest as non-managing member was barred from bringing a derivative action by Section 6.02 of 470 Pearl’s operating agreement (read here) which vested sole management authority in BDC and which, in Section 6.02(h) as interpreted by BDC in its supporting brief (read here), required that any litigation brought in the LLC’s name “must be commenced by the Manager after getting the consent of the other Member.” Univest’s opposing brief (read here) argued that Section 6.02(h) merely restricted BDC’s authority as manager to commence litigation in 470 Pearl’s name, not Univest’s, and that Univest’s right to sue on behalf of 470 Pearl was based on the common-law right of LLC members to sue derivatively as recognized by New York’s highest court in Tzolis v Wolff, 10 NY2d 100 .
Justice Walker, in his decision dated November 26, 2014 (read here), denied BDC’s dismissal motion, finding that BDC “has pointed to no language in the [operating agreement] that eliminates [the right to commence a derivative action] which — the Court notes — did not firmly exist prior to the Court of Appeals decision in 2008 in Tzolis v Wolff” which post-dated 470 Pearl’s operating agreement by three years, i.e., the operating agreement could not have been intended to restrict Univest’s right to sue derivatively when no such right existed at the time.
Justice Walker further observed that “[m]any derivative actions are brought by parties who, were they not suing derivatively, would lack the authority to bring actions on behalf of the corporation or LLC. Thus the demand requirement.” Upon finding that Univest’s demand upon BDC was excused because of BDC’s affiliation with Skydeck, and that Univest’s petition stated valid grounds for evicting Skydeck upon the termination of its lease as previously adjudicated, Justice Walker ordered the issuance of a warrant of eviction.
BDC’s subsequent motion for reconsideration sought to bolster its argument that the Tzolis decision left open the extent to which the common-law right of LLC members to sue derivatively may be limited, and that the provisions of 470 Pearl’s operating agreement constituted an enforceable, contractual waiver of Univest’s right to seek derivative relief. Last week Justice Walker issued a letter-decision (read here) denying the motion without further comment. (Read here BDC’s opening brief; here Univest’s opposing brief; and here BDC’s reply brief.)
The question lurking in the background but not decided in Univest, whether an LLC member’s common-law right under Tzolis to bring a derivative action can be waived ex ante, to my knowledge has not been decided by any New York court. In Delaware, where the right to sue derivatively exists by statute, any such waiver is prohibited by Section 18-109(d) of the LLC Act. Last year, writing on his Kentucky Business Entity Law blog, Tom Rutledge expressed concern over dicta in a decision by the Kentucky Court of Appeals in which the court noted in passing the trial court’s determination that a non-managing LLC member lacked authority to maintain a derivative action based on the operating agreement’s provision barring any action on the LLC’s behalf without the manager’s consent.
It bears emphasizing that in both Univest and the Gorbrook case mentioned above, the derivative eviction proceedings were aimed at tenants who had close affiliations with the LLC’s controller. It could be argued that under those circumstances, as Justice Walker noted, the demand requirement (and its exceptions) adequately protect the legal and equitable interests of all parties and the LLC, without unduly interfering with the fiduciary-infused exercise of management rights. Query, however, whether the demand requirement adequately protects the LLC and management rights from derivative litigation against unaffiliated tenants (or other third parties), where the damage is done the moment the suit is brought whether or not it survives the pleading stage, and where a waiver provision might provide the quickest path to dismissal. For instance, would a court enforce a waiver provision in the operating agreement of a realty company prohibiting a non-managing member from bringing a derivative action against unaffiliated (however defined) tenants? Perhaps, as lawyers who draft operating agreements continue to push the LLC freedom-of-contract envelope, such questions will be the subject of future litigation and a future post on this blog.