[N.B. Younger readers of this post may be forgiven for not catching the title’s play on the refrain of a certain 1976 hit song by one of the oldest and most hirsute recording groups around. Click here if you’re still stumped.]
LLC deadlock’s been on my mind more than usual of late, after interviewing LLC maven John Cunningham for a podcast and last week co-presenting with John a webinar on the subject for the ABA Young Lawyer’s Division.
During the webinar’s Q&A session, a listener asked about potential liability of an appointed deadlock tie-breaker. I mentioned that I had not seen any cases involving the issue. Lo and behold, several days later up popped a decision by Queens County Commercial Division Justice Martin E. Ritholtz presenting exactly that issue, in which the court denied the tie-breaker’s motion for summary dismissal of a claim brought against her for breach of fiduciary duty by one of two 50/50 members of a family-owned LLC. Fakiris v Gusmar Enterprises LLC, 2016 NY Slip Op 51665(U) [Sup Ct Queens County Nov. 21, 2016].
Fakiris involves a realty company based in Long Island City, organized as an LLC in 1997 by Pantelis Fakiris as sole manager, together with his son Kostas and his daughter Marina. The father died in 2013, after which Kostas and Marina as 50/50 members amended the operating agreement to designate themselves co-managing members. The amended agreement also included the following tie-break provision:
[I]n the event that the company decisions result in a stalemate between the Managing Members, then a third party, namely Donna Neubauer, shall cast the decisive vote to resolve such stalemate.
The decision does not indicate whether Neubauer signed the operating agreement or any other document recording her agreement to serve as tie-breaker.
What followed is a classic example of what Professor Ben Means refers to as a “spillover dispute” in the context of family-owned businesses. The sibling acrimony first erupted when Marina sued their mother over the father’s estate, and Kostas sided with the mother. The family falling-out intensified when Marina next sued their mother seeking her eviction from property they jointly owned and the payment of back rent.
The fight eventually bled onto the realty company, centering on three flashpoints:
- Marina’s refusal to execute a favorable mortgage refinancing agreement for two of the LLC’s three rental properties, resulting in the mortgages going into default;
- Marina’s refusal to release from attorney escrow almost $500,000 insurance proceeds secured on the LLC’s behalf in settlement of litigation with the insurer; and
- Marina’s attempt to terminate the tenancy at one of the LLC’s properties of a company owned 100% by Kostas.
The court’s decision provides only a few details about the tie-breaker’s conduct amidst the turmoil. Justice Ritholtz mentions that Neubauer serves as comptroller of the LLC, comptroller of Kosta’s separately-owned company also named as defendant in Marina’s lawsuit, and that the LLC (presumably on Kosta’s sole authority) made college tuition payments for Neubauer’s children. There is no mention of any specific tie-breaking votes cast by Neubauer.
The decision relates that, because of the sibling acrimony, Neubauer resigned as tie-breaker and thereby “relinquished her authority to cast the decisive vote in case of a deadlock between the managing members,” and that Kostas and Marina thereafter failed to appoint a successor tie-breaker as provided in the operating agreement when Marina “rejected the candidates proposed by Kostas and refused to propose another candidate.”
The Claim Against Neubauer as Tie-Breaker
As described in the decision, Marina’s complaint asserted direct and derivative claims against Neubauer for breach of statutory and common-law fiduciary duty, unjust enrichment, and negligence for alleged misconduct involving both her designated tie-breaker role and outside that role stemming from her alleged misconduct as comptroller/employee of the LLC and Kostas’ separate company also named as a defendant in connection with its tenancy at one of the LLC’s properties.
The direct claim against Neubauer for breach of fiduciary duty as tie-breaker, as described in the decision, alleges that the operating agreement’s tie-breaker provision creates a fiduciary relationship between Neubauer and Marina, and that Neubauer breached her duty “by refusing to resolve stalemates between the plaintiff and Kostas, including those that pertain to alleged unauthorized withdrawals and the repayment of loans.”
Following completion of discovery Neubauer moved for summary judgment dismissing each of Marina’s claims against her. While Justice Ritholtz denied the motion in all respects, I’ll only address his denial of the motion concerning Neubauer’s tie-breaker role.
Justice Ritholtz’s decision quotes the definition of fiduciary relationship found in commentary to the Restatement [Second] of Torts § 874 as one that “exists between two persons when one of them is under a duty to act for or to give advice for the benefit of another upon matters within the scope of the relation.”
He then finds that “there was a fiduciary relationship between the plaintiff and Neubauer arising from the operating agreement” and that “there are issues of fact pertaining to this cause of action as asserted against Neubauer which preclude summary judgment for either side,” including “whether defendant Neubauer was ever requested to act as tie-breaker and whether she took improper payments (e.g., tuition payments for her children from [the LLC].”
Unfortunately, that’s the full extent of the court’s analysis of the issue. The decision does not cite any case precedent or other authority involving a claim against a tie-breaker for breach of fiduciary duty.
The absence of details in Fakiris makes it a less-than-ideal candidate for examining the issue whether and under what circumstances an LLC tie-breaker can be held liable for breach of fiduciary duty. The court’s denial of Neubauer’s dismissal motion nonetheless raises a host of interesting questions. Here are just a few:
- Absent language in the operating agreement expressly imposing a fiduciary duty on the tie-breaker, is the duty more appropriately viewed as a contractual one? If so, in a case with a tie-break provision such as the one in Fakiris, the consequences of a breach would seem to be narrowly confined to any damages arising from the failure to cast a tie-breaking vote, proof of which may be very difficult and made even more complicated by the members’ own participation in creating the deadlock.
- If there is a fiduciary duty, should it extend to the members as found in Fakiris or only to the LLC? The latter is suggested if we analogize someone in Neubauer’s position to a non-shareholder, non-controlling director of a corporation whose duty generally is owed to the corporation alone. Also, does Fakiris truly involve a direct claim based on a duty owed to Marina? The decision’s sparse description of her claim mentions only that Neubauer refused to break deadlock over “alleged unauthorized withdrawals and the repayment of loans,” which sound more like derivative claims for breach of duty owed to the LLC.
- Is there a stronger case in theory for imposing fiduciary liability on a tie-breaker who, instead of refusing to break a deadlock, casts a deciding vote either causing the LLC to take the disputed action or blocking it from doing so and thereby causing injury to the LLC? For example, suppose a tie-breaker casts the decisive vote authorizing the LLC to pay one 50% member a clearly exorbitant and unjustifiable bonus. One can imagine a derivative claim being stated against the tie-breaker under that circumstance for breach of fiduciary duty or, at a minimum, aiding and abetting breach of fiduciary duty.
- Many states have statutes authorizing courts to appoint a provisional director to resolve deadlocked boards, including Delaware General Corporation Law § 353 applicable to statutory close corporations. The LLC laws in a few states give courts similar powers to appoint a provisional manager, e.g., New Jersey Revised LLC Act § 42:2C-48(b). Should case law construing potential tie-breaker liability under these statutes apply to tie-breakers designated in an operating agreement, or does the judicial overlay for statutory appointments provide a protective cloak unavailable to non-statutory appointments absent provision in the operating agreement?
The possibility of tie-breaker liability is best addressed ex ante by counsel responsible for drafting the operating agreement and, of course, by counsel for anyone brave enough to serve as tie-breaker. If I’m counseling the prospective tie-breaker, naturally I will insist on protective terms waiving or sharply limiting liability and indemnifying the tie-breaker for any damages and legal expenses.
Another issue in drafting tie-break provisions concerns naming a successor for the designated tie-breaker who resigns, declines to serve, or dies. The operating agreement in Fakiris apparently called for the two members to nominate and appoint a successor to Neubauer but provided no way to overcome Marina’s refusal to consent to Kosta’s nominee or force her to name her own nominee. In other words, it permitted an unresolvable deadlock over the appointment of a successor tie-breaker. One of the more common drafting techniques to avoid this problem is to designate by name one or more successor tie-breakers.
By the Way, the Court Also Dissolved the LLC
The primary issue in Fakiris — as far as practical consequences go — was not Marina’s claim for tie-breaker liability, but her brother Kosta’s counterclaim for judicial dissolution of the LLC under LLC Law § 702 on the ground that the management of the company had become so dysfunctional that it was no longer reasonably practicable to operate the business in conformity with the operating agreement.
Justice Ritholtz agreed with Kosta and ordered dissolution, citing the deadlocks over refinancing the mortgages, the tenancy of Kosta’s separate company, and the release of escrowed settlement funds; the litigation claims against one another and by Marina against Neubauer; and the inability to replace Neubauer as tie-breaker.
Justice Ritholtz also appointed a permanent receiver under LLC Law § 703 to wind up the LLC’s affairs. For those interested in what a formal order of appointment looks like, including a detailed recitation of the receiver’s powers, check out the last few pages of the judge’s decision.