It’s been over 21 years since New York enacted its LLC Law, during which we’ve only seen a handful of court decisions concerning a member’s right to inspect company books and records under LLC Law § 1102. A first impression decision last month addressed not the scope of inspection, but whether inspection can be conditioned on an undertaking not to disseminate the information obtained or to contact other members whose identities are disclosed by the inspection.
Let’s begin with a few basics. Managing members of a limited liability company normally require unrestricted access to, and control over, company books and records, which is right and proper given their supervisory and fiduciary roles in regard to company operations and finances. Non-managing members generally have a narrower but nonetheless vital interest in gaining access to company books and records, centered on monitoring the activities of, and potential abuses by, the managers as agents of the LLC, and keeping themselves apprised of the company’s financial condition and the value of their investment.
Section 1102 of New York’s LLC Law, which in large part was patterned after Section 121-106 of the state’s Revised Limited Partnership Law, contains both mandatory and default rules governing the maintenance of, and member access to, books and records. Sections 1102 (a) and (b) mandate that “any member” has the right to inspect “for any purpose reasonably related to the member’s interest as a member” certain minimal records that must be maintained by the LLC including the names and addresses of all managers and members, the LLC’s articles of organization and operating agreement, and tax returns for the three most recent fiscal years, plus such “other information regarding the affairs of the [LLC] as is just and reasonable.”
At the same time the statute recognizes management’s competing interest to control and even limit both the logistics and scope of inspection. Under Section 1102 (b), the manner and circumstances of inspection are subject to “reasonable standards as may be set forth in, or pursuant to, the operating agreement.” For instance, it’s typical to find in operating agreements provisions requiring a written demand for inspection, regulating the time and place of inspection, and specifying the requesting member’s obligation to pay the costs of inspection.
The LLC’s authority to withhold from members information deemed confidential or the dissemination of which might otherwise harm the company is provided in Section 1102 (c), as follows:
If provided in the operating agreement, certain members or managers shall have the right to keep confidential from other members for such period of time as such certain members or the managers reasonably believe to be in the nature of trade secrets or other information the disclosure of which such certain members or the managers in good faith believe is not in the best interest of the [LLC] or its business or which the [LLC] is required by law or by agreement with a third party to keep confidential.
Section 18-305 (c) of Delaware’s LLC Act has a similar provision, with one important difference: the Delaware provision authorizes the manager to withhold confidential information whether or not such authority is spelled out in the operating agreement. Section 410 (g) of the Revised Uniform LLC Act likewise authorizes the LLC “as a matter within the ordinary course of its activities” to impose “reasonable restrictions and conditions on access to and use of” company information including confidentiality requirements.
The S&H Nadlan Case
In S&H Nadlan, LLC v MLK Associates, LLC, 2016 NY Slip Op 30523(U) [Sup Ct NY County Mar. 7, 2016], Justice Donna M. Mills of the Manhattan Supreme Court last month granted summary judgment in favor of minority members of two real estate holding LLCs, ordering the managing member to provide them a “full inspection” of the companies’ books and records without conditioning disclosure on their entering into a confidentiality agreement limiting their use and dissemination of the information or prohibiting them from contacting other LLC members whose identities are disclosed in the records.
The plaintiffs initially were minority participants in two real estate loans in which the borrowers defaulted resulting in the lenders taking deeds in lieu of foreclosure. As a result the plaintiffs became minority non-managing members in two LLCs created to hold title to the two properties formerly owned by the defaulting borrowers.
Beginning in February 2015, the plaintiffs’ lawyer sent the managing member a series of written demands to inspect company records including those mandated by LLC Law § 1102(a) — list of members, articles of organization, operating agreements, tax returns for three most recent fiscal years — plus other information including financial statements, appraisals, rent roll, bank statements, loan documents, and meeting minutes.
Plaintiffs filed suit after the managing member refused to permit an inspection unless the plaintiffs formally agreed in advance that all company information provided would be treated as confidential and that plaintiffs would not discuss the information with other LLC members or even contact other members whose identities apparently remained unknown to the plaintiffs. The complaint (read here) asserted causes of action for declaratory judgment enforcing plaintiffs’ inspection rights and an accounting.
The defendant managing member’s answer alleged that it was prepared to provide the plaintiffs with access to “relevant” books and records “upon the execution of a confidentiality agreement [which] Plaintiffs have refused to sign.” The proposed confidentiality agreement was a standard form used in litigation proceedings which, among other restrictions, would allow the managing member initially to designate all documents as confidential and would prohibit the recipient’s use of confidential information for any purpose other than the litigation.
The plaintiffs offered to sign the agreement with certain exceptions including the right to disclose the information to other members of the companies. The managing member refused this exception and also refused to identify other members unless the plaintiffs agreed not to contact them.
In his affidavit opposing plaintiffs’ subsequent summary judgment motion, the managing member gave as his reason that the plaintiffs never contemplated becoming members of the then non-existent LLCs at the time they agreed to participate in the real estate loans, did not at that time demand the identities of the other loan participants, and had “no reason for the disclosure of this information at this time.” He also contended that the plaintiffs “intend to contact other members of [the LLCs] in order to solicit the sale of their membership interests and to solicit other, unrelated investments” and that “the privacy rights of the members of [the LLCs] must be respected.”
In her decision, Justice Mills gave short shrift to the managing members’ objections to inspection, highlighting the plaintiffs’ statutory rights and the managing member’s failure to offer the LLCs’ operating agreements in support of his position. Here’s what she wrote:
In opposition, defendants have failed to produce the operating agreements of the LLCs, or any other evidence, to demonstrate that there are restrictions on plaintiffs’ right to inspect the LLCs’ books and records and/or restrictions on plaintiffs’ right to contact the other LLC members. Moreover, defendants’ unsubstantiated and speculative allegations that plaintiffs want to contact the other members of the LLC to solicit the sale of their memberships or to solicit other, unrelated investments and/or that the other members’ privacy rights must be respected, is insufficient to overcome plaintiffs’ prima facie showing that they are entitled to inspect the LLCs’ books and records and contact the other members of the LLCs.
The court’s order compels the managing member to grant plaintiffs an unconditional, “full inspection of the books and records” which, at least from the managing member’s point of view, is worse than if he had accepted the plaintiffs’ pre-litigation offer to enter into a limited confidentiality agreement.
- Maintaining confidentiality of sensitive business information is a must for any business. The S&H Nadlan decision underscores the imperative under LLC Law § 1102 that drafters of New York LLC operating agreements include express, detailed provisions authorizing reasonable restrictions on member access to, and use of, confidential information.
- In the absence of such authorization in the operating agreement, could a New York court nonetheless condition inspection rights on maintaining the confidentiality of designated sensitive information? The issue was not briefed in S&H Nadlan nor have I seen it addressed in any other New York cases. My guess is that a court could rest its authority to do so on § 1102 (b)’s proper-purpose requirement, that is, a member’s interest in disseminating confidential business information to third parties (other than the member’s own agents such as legal counsel and accountants) is not a purpose “reasonably related to the member’s interest as a member.”
- Could a court condition inspection rights on a member’s undertaking not to contact other members whose identities are thereby disclosed? That strikes me as highly unlikely (I won’t say impossible, under special circumstances) given the express statutory requirement that the LLC maintain and make available for inspection a list of the members, and based on the fundamental right of a business owner to know the identity of the other owners and to be able to communicate with them on matters of common interest.