Unless otherwise provided in the operating agreement, majority members of LLCs formed under New York law — and under the LLC laws in most other states — effectively can expel a minority member by implementing a merger with another company owned by the majority members. The so-called freeze-out merger (a/k/a cash-out merger) compels the minority member to accept cash for his or her membership interest in lieu of equity in the surviving entity. The statutes generally protect the frozen-out member to the extent of providing the right to dissent from the merger and to demand a fair-value judicial appraisal.
As best as I can tell, until last month there were exactly four reported court decisions in New York involving challenges to LLC freeze-out mergers, each of which I’ve covered on this blog. In three of them — the Stulman case, the Alf Naman case, and the Slayton case — trial judges rejected various procedural and substantive objections to the mergers by the minority members. In the fourth case (SBE Wall), the trial judge denied a motion to dismiss an action seeking to invalidate a freeze-out merger, but the merger was never enjoined or rescinded and the case eventually settled.
Along comes a fifth case decided last month by Manhattan Commercial Division Justice Charles E. Ramos — who also decided the Stulman case — in which he denied the frozen-out minority members’ preliminary injunction motion seeking to enjoin the merger’s implementation after finding no basis for the minority members’ claim that the merger breached the operating agreement. Huang v Northern Star Management LLC, 2016 NY Slip Op 32194(U) [Sup Ct NY County Oct. 24, 2016].
The Huang case involves a single-asset realty holding company that owns a mixed use property in Flushing, New York. On the heels of settling a prior lawsuit among the LLC’s members over a disputed refinancing of a mortgage loan, the four majority members collectively holding 67% of the membership interests executed a freeze-out merger.
The merger proceeded in two steps. First, pursuant to an Exchange Agreement the majority members swapped their aggregate 67% membership interests in the existing LLC (“Oldco”) for an aggregate 100% membership interest in a newly formed LLC (“Newco”). Second, Newco executed a written consent in lieu of meeting authorizing the merger of Newco into Oldco, with Oldco as the surviving entity. Under the merger agreement, Newco’s membership interest in Oldco was cancelled for no consideration and the Oldco membership interests held by the three minority members were converted into the right to receive approximately $2.9 million cash.
Two of the three minority members holding an aggregate 27.5% membership interest in Oldco filed suit and simultaneously moved for a preliminary injunction to prevent the merger’s implementation. Their complaint and motion contended that the merger violated Oldco’s operating agreement and therefore was invalid. Specifically, the plaintiffs relied on Section 9.3 of the operating agreement providing in pertinent part that a member “may transfer his interest in the LLC to another person or entity . . . only with the prior majority consent of other Members either in writing or at a meeting called for such purpose.”
In their supporting brief and at oral argument (read transcript here), the plaintiffs argued that Section 9.3 required the approval of a disinterested majority and, therefore, the Exchange Agreement by which the interested majority members jointly and concurrently transferred their membership interests in Oldco to Newco was invalid, thereby invalidating Newco’s authorization of the merger agreement.
The defendants countered that the word “disinterested” nowhere appears in Section 9.3 and that, even without the minority members’ votes, each transfer by the majority members had the requisite majority consent of the “other members.” In other words, as to each individual transfer by the four members collectively holding 67%, the votes of the other three members in the group of four exceeded the 33% held by the three minority members.
At the hearing, counsel for the plaintiffs argued that Section 9.3 requires consent of a majority of disinterested members by analogy to the statutory restrictions on voting by interested directors of corporations. The analogy fell flat with Justice Ramos who commented at pages 19-20 of the transcript that, just as corporation shareholders are entitled to vote their interest, so too can LLC members.
Justice Ramos’ subsequent written decision denying injunctive relief focused on the language of Section 9.3 which, he wrote, “is completely devoid of the term ‘disinterested,’ which is the crux of the [plaintiffs’] application.” He continued:
The plain language of the provision the [plaintiffs] cite clearly permits a member to transfer their membership interest upon approval by a simple majority of members. It does not state that a majority of the disinterested members is required, as the [plaintiffs] assert.
[Defendants] clearly establish that for each of the four Majority Members each obtained majority consent from the other three Majority Members for their respective transfers. In each instance, the three non-transferring Majority Members held over 33% of the [Oldco] membership interests, which was the collective [Oldco] membership interest of the Minority Members. Consequently, the Minority Members never held enough membership interest in [Oldco] to prevent or challenge the transfers.
It’s interesting to note that the Oldco operating agreement’s so-called “major decisions” provision required 65% member approval for “the merger of the LLC with another limited liability company.” The 67% majority thus could have avoided any controversy over the transfer of their membership interests, and still forced a cash-out of the minority, by instead authorizing a forward merger of Oldco into Newco with Newco as the surviving entity. I’m guessing it wasn’t done in this simpler fashion because of potential complications vis-à-vis Oldco’s mortgage loan.
The Huang case represents a straightforward application of Section 1002(g) of New York’s LLC Law which, unlike its broader counterpart in Section 623(k) of the Business Corporation Law, provides extremely narrow exceptions to the otherwise exclusive, statutory appraisal remedy granted a dissenting member. The exceptions are (1) non-compliance with the operating agreement and (2) absence of the requisite member approval. The plaintiffs in Huang failed to convince Justice Ramos that either exception applied. They have since filed a notice of appeal, so perhaps some day we’ll see the first appellate ruling in New York addressing LLC freeze-out merger.
Update November 23, 2016: Over at the superb Kentucky Business Entity Law blog, Tom Rutledge offers additional analysis of the Huang case with a focus on the court’s non-aggregation of the majority members’ voting interests in connection with their approval of the transfers, and the implications for drafters of operating agreements.