I wish I could take credit for it, but I can’t. The phrase “bare naked assignee” was coined by the preeminent scholar and LLC maven Professor Daniel Kleinberger whose massive oeuvre (not to mention his guest posts on this blog here and here) includes a wonderful article published in 2009 called The Plight of the Bare Naked Assignee (available here on SSRN ). As described in the abstract, the article addresses the “new and separate opportunity for oppression” that “exists because LLC law purports to (1) recognize a species of persons holding legal rights vis-á-vis the LLC (assignees) while (2) denying those persons any remedies whatsoever in connection with those rights.”
Under the LLC statutes in New York and most other states, except as otherwise provided in the operating agreement, LLC membership interests are freely assignable in whole or in part. As the Professor’s article explains, the bedrock “pick your partner” principle of partnership law found expression in the default rules of LLC statutes which, contrary to traditional corporation laws, require majority (or unanimous) consent of the other LLC members for an assignee to become a full-fledged member with both economic and voting/management rights. Typical of these statutes, New York’s LLC Law § 603 provides that, absent such consent, the assignee has no right to participate in LLC management “or to exercise any rights or powers of a member” and only has the right “to receive, to the extent assigned, the distributions and allocations of profits and losses to which the assignor would be entitled.”
The vast majority of written operating agreements that I’ve encountered include detailed articles addressing the rights of members to assign (or not) their membership interests and, when permitted, what if any rights non-member assignees possess other than the right to receive distributions and profit/loss allocations. Of course, absent an operating agreement, the rights of an assignee are governed by the statutory default rules.
The Professor’s article broadly discusses theory and case law surrounding the difficulties faced by non-member assignees a/k/a transferees — oftentimes the heir of a deceased member — when it comes to protecting their economic interests against managerial abuse by the LLC’s controllers. My focus here addresses only one, narrow aspect of such protection, namely, the ability of a non-member assignee to inspect LLC records in the absence of dispositive rules in an operating agreement or, as in what I believe is a small minority of states including Texas, a statute giving assignees inspection rights.
In New York, LLC Law § 1102 (b) gives “any member” the right to “inspect and copy at his or her own expense, for any purpose reasonably related to the member’s interest as a member,” the LLC’s organizational documents including operating agreements, lists of managers and members specifying profit interests, the last three years of tax returns and financial statements, and “other information regarding the affairs of the limited liability company as is just and reasonable.” Section 18-305 of Delaware’s LLC Act likewise provides inspection rights to “Each member of a limited liability company,” as does Section 410 of the Revised Uniform LLC Act.
Both § 102 (q) of New York’s LLC Law and § 18-101 (11) of the Delaware LLC Act define “member” as someone “admitted” to the LLC. Under New York LLC Law §§ 603 and 604, and under Delaware LLC Act §§ 18-702 and 18-704, an assignee is not admitted to membership unless the other members consent.
Looking only at the statutory definitions of member and the references in the inspection statutes to the right of a member to demand inspection, one certainly can argue that, absent language providing otherwise in the operating agreement, a non-member assignee of a membership interest does not have inspection rights.
No Case Law
There are relatively few New York cases addressing rights of inspection under LLC Law § 1102, and of those, none involve demands for inspection by non-member assignees. In fact, I’m not aware of any reported case in any jurisdiction adjudicating a demand for inspection by a non-member assignee under the statutory default rules. Like water seeking its own level, inevitably such cases will arise.
Mind you, there are a fair number of cases in New York and other jurisdictions in which courts have ruled that non-member assignees do not have standing to bring derivative claims. I’ve written about some of them on this blog, e.g., the Budis case (here) and the Lewis case (here). But, at least arguably, derivative claims, which seek recovery for the benefit of the LLC based on alleged wrongdoing by LLC controllers in connection with their management of the LLC’s affairs, implicate interests and policies different from a non-member assignee’s direct claim for access to the LLC’s records for the purpose of protecting the assignee’s right to receive distributions and profit/loss allocations. It’s therefore debatable whether cases denying standing to assignees to sue derivatively should deny them standing to inspect LLC records.
The Lotton Case
In a Minnesota case called Lotton v Savich Herefords, LLC in which Professor Kleinberger testified at trial as an expert witness, the plaintiffs, who received by assignment from their deceased father’s estate his economic rights in the LLC, sued the remaining active member for breach of fiduciary duty, alleging various acts of waste and mismanagement of LLC assets. Among the relief sought was an order appointing an accountant to conduct a full audit of the company.
Although Lotton is not a books-and-records case per se, the equitable underpinnings of the court’s ruling, and the remedy it allows, gives a toehold to the argument that the “bare naked assignee” should be entitled at the least to some right to inspect LLC records for the purpose of protecting their economic interests.
The defendants in Lotton understandably contested the non-member plaintiffs’ standing to bring the claims. “As a matter of statute,” Professor Kleinberger wrote in his article, “the defendants’ position should have prevailed” in that the Minnesota LLC Act “clearly follows the partnership-style bifurcation of membership rights into economic rights and other rights.”
Nonetheless, the idea that the plaintiffs had no means to protect their economic interest in the LLC did not sit well with the judge. Here’s how Professor Kleinberger described (and quoted from) the court’s decision:
Unfortunately, for the defendants–at least as an initial matter–the judge would not accept the anomalous notion that a person might have rights but “no means of protecting their interest.” In the situation of a bare naked assignee, some recourse must exist:
In cases where the member who transferred the financial rights remains alive and retains governance rights, that member can act to protect the rights of his assignees. Where, as here, the rights were transferred upon the death of a member, there is no one left with governance rights to protect the interest of the assignees and there must be some mechanism for the assignees to protect their financial interest. . . .
The court would not accept that result. There was a right; there must be a duty whose breach would give rise to a remedy.
The court in Lotton then proceeded to locate an LLC manager’s duty to an assignee in the section of Minnesota’s LLC Act, analogous to § 409 of New York’s LLC Law, setting forth a general standard of care for anyone acting as a manager of an LLC, which the court construed as “imposing upon the manager a fiduciary duty to anyone with a membership and/or financial interest in the company.”
As Professor Kleinberger put it, the court then had to “cabin in its holding” so as to not run afoul of other provisions in the LLC Act inconsistent with the extension of assignee rights, which it did by “impos[ing] both procedural and substantive limitation on the assignees.”
On the substantive side, the court fashioned a standard akin to the business-judgment rule, limiting a plaintiff to claims for “illegal acts, fraudulent acts, misallocation of LLC assets or profits or other ultra vires acts” as opposed to claims alleging a “poor business decision.”
On the procedural side, Professor Kleinberger wrote, the court’s decision contemplates more than a heightened pleading standard; rather, it requires the plaintiff to make “a prima facie showing that defendants have breached a fiduciary duty.” Here’s how the court put it:
[I]t would be contrary to the overriding intent of [the Minnesota LLC Act] to permit financial interest assignees to bring baseless claims in an effort to compel the company to provide them with company records, financial statements, or any notices from the company. Therefore, before an assignee may compel a company to disclose any such documents as part of the discovery process on a breach of fiduciary duty claim, the complainant must make some showing of a valid basis for the claim.
The decision gave the plaintiffs 45 days to make the required showing. According to Professor Kleinberger, “the plaintiffs utterly failed at that task” ultimately prompting the court to dismiss their lawsuit.
The moral of this story,” the Professor summed up,
is that judges, unlike the Red Queen in Alice in Wonderland, are unlikely to believe ‘six impossible things before breakfast.’ A property interest established and recognized by statute, but with its owners bereft of “any means of protecting their interest,” is an impossible thing.
He then concluded his article — and I’ll conclude this post — with his own blueprint of how “a more refined formulation” might look using “equitable intervention” as “a narrower avenue than expanding standing.”
- Statutory limitations on assignee access to information should remain effective, except by court order (as provided below). Any other approach would categorically override statutory language and fundamentally undermine the “pick your partner” principle.
- A court should not grant an assignee additional information rights before the filing of a complaint.
- Upon filing of a complaint, discovery should be stayed pending an initial determination on the sufficiency of the complaint.
- To avoid prompt dismissal on the pleadings, a complaint should have to
- plead with particularity facts, which,
- if true,
- would establish a prima facie case that
- those in control of the limited liability company have
- without plausible business justification, and
- not as the result of mere errors in judgment,
- done or threaten to do one or both of the following:
- destroy or substantially diminish the value of the claimant assignee’s financial interest in a manner that benefits one or more members of the LLC
- target the claimant assignee’s interests for substantially and invidiously inferior treatment when compared to the treatment of comparable financial interests owned by members.
- If a complaint survives a motion to dismiss, the court should determine whether to allow regular discovery or, instead
- itself or by special master
- make an in camera inquiry into the books and records of the limited liability company
- in order to determine whether substantial evidence exists to support the allegations and permit full discovery to proceed.
Whatever the precise standards and procedures, three fundamental points must remain in view:
- A characteristic of every LLC (and partnership) statute in the country is a sharp dividing line between full owners and mere assignees of financial rights.
- Courts should overlook that dividing line only when faced with well-pleaded, detailed claims of abuse that has been targeted at the assignees.