The pick-your-partner principle is universally embedded in the default rules of limited liability company enabling acts, including Sections 601 through 604 of the New York LLC Law which permit free assignment of distributional and other economic rights appurtenant to a membership interest but require the other members’ consent before an assignee is granted full member status with voting and other rights associated with membership in an LLC.
The distinction between a “mere” assignee versus a transferee with member status can become a battle ground when a putative LLC member who received his, her or its interest by assignment brings legal action against the LLC’s managers for dissolution, access to books and records, or asserting derivative claims on behalf of the LLC. That’s because by statute and/or common law, the suing party’s requisite legal standing to assert such claims depends on having member status.
A recent decision by Manhattan Commercial Division Justice Saliann Scarpulla in MFB Realty LLC v Eichner, 2016 NY Slip Op 31242(U) [Sup Ct NY County June 24, 2016], in which she dismissed derivative claims by a mere assignee of LLC interests, starkly illustrates the distinction and the importance of compliance with the LLC agreement’s provisions for bestowing member status on assignees.
The controversy in MFB Realty stemmed from a multi-member LLC formed in the mid-1990s for a timeshare residential condominium project at a Manhattan location. The LLC’s operating agreement defined “Member” as the original, named members and “persons hereafter admitted as Members.” In the article governing transfers of membership interests, Section 7.1 required prior written consent of 95% of the non-transferring members for any assignment by a member of “all or any portion of his, her or its interest in the Company.”
Section 7.2, captioned “Permitted Transfers,” allowed assignment to Permitted Transferees defined as lineal descendants of the parents of the members and the spouses of such descendants. It also included the following provision concerning member status that ultimately played a dispositive role in Justice Scarpulla’s decision:
Notwithstanding anything contained in this Agreement to the contrary, no Permitted Transferee or any other transferee shall become a Member without the written consent of Members owning [95%] of the Membership Interests, which may be arbitrarily withheld.
In December 2005, two non-managing members obtained the advance written consent of 95% of the other members for an assignment of their aggregate 10% membership interest to MFB Realty LLC which was owned by the two assigning members and certain lineal descendants of one of them. The written consent’s operative language stated that the consenting members “hereby consent . . . to any transfer . . . of any direct or indirect interests in the [LLC] to [MFB Realty].”
The assignment and assumption agreement with MFB Realty, a copy of which also was delivered to the other members in September 2006, stated that it was assigning “all of each Assignor’s interests” in the LLC “together with all such Assignor’s right, title and interest in and to the Company in respect of the Assigned Interest, including, without limitation, such Assignor’s capital account therein . . ..”
You can view here copies of the written consent and the assignment. Notice that neither of them contain any explicit reference to voting rights or the admission of MFB Realty as a member of the LLC.
Which is exactly what Justice Scarpulla not only noticed, but found dispositive in MFB Realty’s lawsuit brought in 2014 against the LLC’s managing members asserting derivative claims accusing them of operating a competitive business utilizing the LLC’s resources and credit.
The judge began her analysis with recognition of the pick-your-partner principle reflected in the LLC Law’s default statute:
The Limited Liability Company Law accords the members of an LLC the right to choose their fellow members, and provides that, “[e]xcept as provided in the operating agreement, an assignee of a membership interest may not become a member without the vote or written consent of at least a majority in interest of the members, other than the member who assigned or proposes to assign such membership interest.” Limited Liability Company Law§ 604 (a).
Next, Justice Scarpulla summarized the pertinent provisions in Sections 7.1 and 7.2 of the operating agreement and found that they create a “two-step” process toward the admission of new members:
In addition, the [LLC] operating agreement imposes certain restrictions on the transfer of membership interests, and distinguishes between assignees, or, transferees or permitted transferees, who hold only economic rights, and substituted members, who hold full rights under that agreement and applicable law. The [LLC] operating agreement provides that no member may transfer an interest without the prior written consent of members owning 95% of the [LLC] membership interests. The [LLC] operating agreement additionally provides that, “[n]otwithstanding anything contained in this Agreement to the contrary, no Permitted Transferee or any other transferee shall become a Member without the written consent of Members owning … 95% … of the Membership Interests, which may be arbitrarily withheld.” [Citations omitted]
Thus, under the [LLC] operating agreement two steps are required to obtain . . . member status. First, a [LLC] interest may be transferred only with the prior written consent of members owning at least 95% of the membership interests in [the LLC]. Second, member status in [the LLC] may be transferred only with the written consent of members owning at least 95% of [the LLC’s] membership interests.
Finally, Justice Scarpulla held that the written consent given by the other members in 2006 satisfied the first but not the second of the required two steps:
The documentary record submitted demonstrates that, while MFB obtained the necessary consent to become a transferee under section 7 .1 of the [LLC] operating agreement, it never obtained the written consent required to become a substituted member under section 7.2 of that agreement. In the December 19, 2005 consent letter, the [other members] . . . consented to “any” transfer of [LLC] interests by [the assignors], who together hold a 10% interest. Significantly, however, the consent letter is completely devoid of any express (or implied) reference to the transfer of a membership interest in [the LLC], and nothing in that letter may be interpreted as a consent to the transfer of membership.
Justice Scarpulla accordingly dismissed all of MFB Realty’s derivative claims on the basis that, as a non-member, it lacked standing to assert them. MFB Realty has since filed a notice of appeal, the successful prosecution of which will be required if it is to have any say in the LLC’s business affairs or any role in monitoring the performance of the LLC’s controllers’ fiduciary obligations.
Some of you may be wondering, how could the controversy over MFB Realty’s member status first erupt almost 10 years after the assignment? Easily, at least in a case like this one involving a manager-managed LLC where the operating agreement excludes non-managing members from company management and has no other provisions requiring periodic member meetings or votes.
Finally, while the facts surrounding the consent or lack thereof in MFB Realty seem relatively clear cut precisely because of the formalities that were followed, that is not always the case, especially with LLCs — and even more so with family-owned LLCs — whose members ignore the formalities set forth in the operating agreement and whose course of conduct and representations in and out of court evidence the recognition of assignees as members.