It just got more dangerous to become a minority member of a New York limited liability company without a written operating agreement.
In a case of first impression decided last month, a Manhattan judge ruled that the majority members of an LLC that had no operating agreement at the time of its formation were authorized by statute to later adopt and enforce against a non-signatory minority member an operating agreement that, among other things, authorizes additional capital calls and potentially dilutes the membership interest of a member who fails to contribute.
The facts in Shapiro v Ettenson, 2015 NY Slip Op 31670(U) [Sup Ct NY County Aug. 16, 2015], are fairly simple. In January 2012, three individuals — plaintiff Shapiro and defendants Ettenson and Newman — filed articles of organization for ENS Health, LLC as a member-managed LLC with each member holding a one-third membership interest. From its formation until December 2013, ENS had no written operating agreement. Between September and December 2013, the members negotiated and exchanged draft agreements but none was executed.
In December 2013, Ettenson and Newman, acting under authority of written consent signed by the two of them in lieu of meeting, filed amended articles of organization designating the LLC as manager-managed. They also executed an operating agreement without Shapiro’s consent or signature.
The operating agreement (read here) designated the three members as co-managers. It provided that any action requiring manager approval shall be approved by a majority of the managers, and likewise that any action requiring member approval shall be approved by those holding a majority of the membership interests.
The operating agreement also authorized the members to approve, by majority interest vote, requests to members for additional capital contributions and provided for the adjustment of the members’ percentage interests in the LLC should a member fail to make a requested contribution which is then made up for by the other members.
At a meeting in October 2014, Ettenson and Newman approved resolutions eliminating Shapiro’s $50,000 salary and requesting an additional capital contribution of $10,000 from each member (read here). They also sent Shapiro a capital call notice (read here) advising Shapiro that his membership interest was subject to reduction if he failed to make the contribution, should the other members make up the deficit. Shapiro objected to both actions and filed suit the following month.
Shapiro’s complaint (read here) alleged that the three members orally agreed at its inception to maintain the LLC as a member-managed company; that all decisions would be by unanimous member vote; and that no member’s interest would be diluted in the event of inability or failure to make an authorized capital call. The complaint primarily sought a judgment declaring the operating agreement invalid since it lacked the signature of all three members; declaring invalid the amended articles of organization; declaring invalid the capital call; and declaring invalid the defendants’ vote to eliminate Shapiro’s salary.
In their answer (read here), Ettenson and Newman counterclaimed for reverse relief declaring valid the operating agreement, the amended articles of organization, the capital call, and the vote to eliminate Shapiro’s salary. The counterclaim also sought in the alternative a judgment declaring those actions valid even assuming the operating agreement’s invalidity, i.e., that they were permitted under the LLC Law’s default rules.
The Summary Judgment Motions
The two sides subsequently filed dueling motions for summary judgment. The defendants argued:
- Plaintiff’s alleged oral agreement made at the LLC’s inception, requiring unanimous member consent for all decisions and precluding involuntary dilution of a member’s interest, is unenforceable under LLC Law §§ 102(u) and 417(a) requiring the adoption of a written operating agreement and under case law holding that, absent a written operating agreement, the LLC Law’s default rules function as the statutory operating agreement. In other words, under New York law there is no such thing as an oral operating agreement.
- The written operating agreement executed by defendants without plaintiff’s consent, and the amendment of the LLC’s articles of organization changing it to a manager-managed LLC, are both valid under LLC Law § 402(c)(3) stating in pertinent part, “Except as provided in the operating agreement, . . . the vote of a majority in interest of the members entitled to vote thereon shall be required to . . . adopt, amend, restate or revoke the articles of organization or operating agreement . . ..”
- Under the default rules contained in LLC Law §§ 402(f) and 408(b), even were the operating agreement adopted by defendants invalid, defendants lawfully exercised their majority voting power as members and managers in regard to the amendment of the LLC’s articles, the capital call, and the elimination of plaintiff’s salary.
The plaintiff argued:
- The term “members” as used in LLC Law § 102(u) (“‘Operating agreement'” means any written agreement of the members concerning the business of a limited liability company and the conduct of its affairs and complying with [§ 417] of this chapter”) and § 417(a) (“the members of a limited liability company shall adopt a written operating agreement”) must be interpreted to mean all the members.
- An LLC operating agreement is a contract and therefore cannot bind a non-signatory member.
- Under LLC Law § 417(c), which provides that an operating agreement “may be entered into before, at the time of or within ninety days after the filing of the articles of organization,” the operating agreement entered into by the two defendants almost one year after the LLC’s formation is invalid.
- Under the default rule in LLC Law § 502(c), absent authorization in the operating agreement a member’s interest in the LLC may not be reduced, terminated, or otherwise adversely affected by his or her failure to make an additional capital contribution.
- Under the default rule in LLC Law § 417(b), no amendment of the operating agreement or articles is permitted without the written consent of any adversely affected member, inter alia, concerning the obligation to make contributions or entitlement to distributions and allocation of profit and loss.
For those who wish to dig deeper, read here and here the defendants’ opening and reply briefs, and here and here plaintiff’s opening and reply briefs.
The Court’s Decision
The decision by Manhattan Supreme Court Justice Kelly A. O’Neill Levy begins its analysis by reviewing the various sections of the LLC Law cited by the parties, leading to her agreement with the defendants’ position that LLC Law § 402 authorized them to adopt the LLC’s operating agreement by majority vote and without plaintiff’s consent. Here’s what she wrote:
Under section 402 (a), (c) (3), and (f), Shapiro, Ettenson, and Newman were each entitled to vote in proportion to their one-third ownership interests in order to “adopt, amend, restate or revoke the articles of organization or operating agreement.” Together, Ettenson and Newman owned two-thirds of [the LLC], clearly constituting a majority sufficient, under the LLC Law, to adopt the Operating Agreement and amend the articles of organization. Therefore, Ettenson and Newman have made a prima facie showing that they were authorized to approve and adopt the Operating Agreement and to amend the articles of organization, and that these documents are valid and enforceable.
Justice O’Neill Levy was not persuaded by plaintiff’s reliance on LLC Law § 417, finding that the section neither requires the adoption of an operating agreement by unanimous consent of the members nor prohibits adoption by less than unanimous consent. “In short,” the judge wrote, “Shapiro’s argument is not supported by the plain language of the LLC Law.”
Justice O’Neill Levy also found that the defendants’ capital call did not “trigger,” much less run afoul of, LLC Law § 502 because the contribution was merely “requested” and not obligatory, and because the consequences of failing to make a requested contribution were contained in the operating agreement adopted by defendants as authorized by § 502(c). She also rejected each of plaintiff’s arguments challenging the defendants’ action taken as majority managers to eliminate plaintiff’s salary.
At page 11 of the decision, Justice O’Neill Levy broadly concluded that the actions taken by defendants were lawful even if the operating agreement were deemed invalid, writing:
The court notes that, even assuming for the moment that the Operating Agreement was invalid and there was no written operating agreement, the default provisions of the LLC Law would apply. Under the default provisions, section 401 vested [the LLC’s] management in its three members. Under section 402, Ettenson and Newman held a combined majority interest, thereby permitting them to reduce Shapiro’s salary and issue the capital call. Therefore, defendants’ actions were valid even in the absence of an operating agreement. [Citation omitted.]
The decision accordingly grants summary judgment in favor of the defendants on their counterclaims and dismisses each of the plaintiff’s claims, and includes decretal provisions declaring valid and binding on all the members the operating agreement, the amended articles of organization, the notice of capital call, and the elimination of plaintiff’s salary.
A Few Observations
- For many reasons, whether it’s a family-owned business, a small start-up among unrelated business partners, or even a larger enterprise with persons operating on trust and a handshake — and often without legal counsel — it’s not at all unusual for the prospective co-members to file the minimal articles of organization for an LLC without having first negotiated and signed a written operating agreement. The Shapiro decision, if affirmed on appeal (assuming the plaintiff files an appeal which, so far, he hasn’t) or followed by other trial judges could become a highly dangerous trap for unwary minority members of New York LLCs who, like Mr. Shapiro, could find themselves bound by a subsequently adopted operating agreement they never knew about, much less approved, containing all sorts of potentially prejudicial governance provisions for capital contributions, member expulsion, elimination of management rights, etc. Practitioners must strongly caution any client who wants to become a minority member of a New York LLC to have in place a satisfactory written operating agreement before proceeding. The agreement also should provide for unanimous member approval of any amendments to the operating agreement and articles of organization.
- From what I can tell, the plaintiff in Shapiro did not make an explicit statute of frauds argument, though, as noted above, he did contend that he could not be bound by a “contract” that he never signed. In Delaware, the Chancery and Supreme Courts held in the Olson v. Halvorsen case that, notwithstanding the Delaware LLC Act’s section permitting oral operating agreements, the state’s general statute of frauds applies to LLC agreements, that is, until the Delaware legislature subsequently overruled that case by amendment to the Delaware LLC Act (read here). I’m not aware of any New York cases addressing the issue.
- Speaking of Delaware Chancery Court, last year in Seaport Village Ltd. v Seaport Village Operating Co. LLC (read here), Vice Chancellor Laster ruled that an LLC agreement binds the LLC even if not executed on the LLC’s behalf, in accordance with a 2002 amendment to § 18-101(7) of the Delaware LLC Act explicitly providing that an LLC “is bound by its limited liability company agreement whether or not the limited liability company executes the limited liability company agreement.” The decision notes in passing that “[i]n 2005, the General Assembly added nearly identical language to the LLC Act to clarify that members also are bound by the LLC’s operating agreement, regardless of whether they execute the agreement.” Obviously New York’s LLC Law lacks similar provisions.
- The Shapiro decision, in the passage that assumes arguendo there’s no written operating agreement and nonetheless upholds under the LLC Law’s default rules the capital call and potentially adverse consequences to a member who doesn’t contribute, appears to gloss over the impact of LLC Law § 502(c) which, as New York courts have held (read here), authorizes such consequences only if embodied in a written operating agreement.
Update November 26, 2015: On September 30, 2015, Shapiro’s counsel filed a notice of appeal to the Appellate Division, First Department (read here). Now we wait to see if Shapiro perfects his appeal. Also, Tom Rutledge, on his excellent Kentucky Business Entity Law blog, comments on Shapiro as a lead-in to his discussion whether the same result would obtain under Kentucky’s LLC Act.
Update January 30, 2017: It’s been a long wait, but last week the Appellate Division unanimously affirmed the lower court’s order enforcing the operating agreement based on LLC Law § 402 (c) (3). My report on the appellate ruling is available here.