In 2018, two members of a realty holding LLC sought judicial dissolution based on the death of one of the other members. The operating agreement defines a member’s death as an event of “Dissociation.” A member’s Dissociation automatically triggers dissolution unless all the remaining members consent to continue the company within 180 days after the dissolution event.
The dissolution petition alleged — and it was not disputed, at least insofar as any manner of formal consent — that no member consent was given to continue the company within 180 days of the member’s death. Sounds like a slam dunk for an order of dissolution, right?
Far from it. Between the fact that the deceased member died 11 years earlier and a provision in the operating agreement effectively allowing a deceased member’s interest to be passed to a family member by inheritance without the other members’ written consent, the dissolution petition more closely resembled an out-of-bounds Hail Mary pass than a slam dunk. The lower court summarily dismissed the petition and last week, in Sternlicht v Daniel Z. Rapoport Associates, L.P., 2019 NY Slip Op 08141 [1st Dept Nov. 12, 2019], the appellate court unanimously upheld the lower court’s ruling.
As usual, the story behind the story points to the pressures that build over time when the LLC agreement leaves members with no assured path to liquidity, ultimately leaving litigation as a last and sometimes futile resort for a member seeking to be bought out.
Last week’s post discussed a dispute among members of an LLC that owns a rental apartment building on Manhattan’s Upper West Side. Sternlicht also involves a dispute among members of an LLC that owns a rental apartment building, this time across town on Manhattan’s Upper East Side.
According to the complaint, the two plaintiffs each hold a 7% membership interest in 333 East 54th Street Realty LLC which was formed in 2004 to acquire and operate an apartment building at that address. The plaintiffs filed suit seeking dissolution after the defendant members allegedly declined plaintiffs’ offer to sell their interests based on an $18 million valuation of the building and made a counter-offer at a “steep discount, far below its value,” which the plaintiffs refused.
The complaint alleges that the LLC dissolved under the terms of the operating agreement upon the death intestate of one of the original members in 2007; that the deceased member’s economic interest passed by operation of law to his niece and nephew who “never became members of the Company”; and that “in order to wrongly perpetuate their own lucrative management fees and other self-dealing, Defendants have failed and refused to wind up the Company despite its dissolution.”
The Operating Agreement
- Section 11.1 of the LLC’s operating agreement (“Dissociation”) states that “A Person shall cease to be a Member upon the happening of any of the following events: . . . (c) In the case of a Member who is a natural person, the death of the Member . . ..”
- Section 12.1 (“Dissolution”) states that “The Company shall be dissolved and its affairs wound up, upon the first to occur of any of the following events: . . . (c) the Dissociation of any Member, unless at the time of such Dissociation there are at least two remaining Members and the Company is continued with the consent of all of the remaining Members within 180 days after such Dissociation.”
- Section 1.35 defines a “Substitute Member” as “An Assignee who has been admitted to all of the rights of membership pursuant to Section 10.3 of the Agreement.”
- Subject to certain routine formalities, Section 10.2 (“Transfer of Economic Interest”) freely permits a member to transfer the “right to receive allocations of Profits and Losses and to receive Distributions.”
- Section 10.3 (“Transfer of Membership Interest and Admission of Substitute Member”) prohibits the transfer of a Membership Interest (other than its economic component under Section 10.2) with two exceptions. First, Section 10.3(a)-(c) permits such a transfer if all the other members consent and upon the transferee’s compliance with certain formalities including assumption of any obligations of the transferor to the Company.
- Second, Section 10.3(d) provides, “Notwithstanding the above, if a member desires to transfer their interest to a member’s family, or a trust, or partnership for the benefit of a member’s family, they may do so at any time without restrictions.”
The Lower Court Dismisses
The parties filed dueling motions for summary judgment. In a Decision and Order dated May 6, 2019, Manhattan Commercial Division Justice Andrew Borrok denied the plaintiffs’ motion and granted summary judgment in defendants’ favor dismissing the complaint.
Justice Borrok found that transfers of membership interests to family members “are not subject to the same requirements” spelled out in Section 10.3(a)-(c) and that upon the member’s death in 2007, “pursuant to Section 10.3(d), his [membership interest] was transferred to [his niece and nephew], both family members” who accordingly were “admitted as Substitute Members.” He further commented: “Since then, 11 years have gone by without objection and the members have continued the business and have given their tacit consent.”
The Appellate Court Affirms
The Appellate Division, First Department’s affirmance last week adopts and expands on Justice Borrok’s reasons for dismissal:
- The appellate court adopted almost verbatim Justice Borrok’s findings that the niece and nephew became Substitute Members upon their uncle’s death and that the other members gave their tacit consent as evidenced by the passage of 11 years without objection, adding that Section 12.1 “did not require written consent.”
- The court refuted the plaintiffs’ argument that the lower court’s decision “essentially mooted [Section 12.1’s] consent requirement,” stating that the argument “is belied by the court’s order, which also shows that the court correctly treated the admission of transferees as Substitute Members and the question of the LLC’s continuation after a Member dies as separate issues.”
- The court rejected the plaintiffs’ contention that the lower court improperly “assumed” that a niece and nephew are “family” for purposes of Section 10.3(d), noting that “there are no limitations on degrees of kinship in the Operating Agreement.”
- The court also rejected the plaintiffs’ challenge to the lower court’s implied assumption, that the deceased member’s “intestate transfer sufficed for purposes of ¶ 10.3.” The court wrote that the plaintiffs “offer no grounds for finding that it would not suffice” and that Section 10.3(d) also negated any requirement that the niece and nephew were required formally to assume the obligations of their deceased uncle.
- The court found “unavailing” the plaintiffs’ argument that the lower court’s decision “yields absurd results,” stating: “If a Member wished to bequeath the value of his or her membership interest in the LLC without standing in the way of the LLC’s dissolution, then he or she could transfer or bequeath the unit(s) of Membership without the family member transferee also becoming a Substitute Member, a transaction contemplated in ¶ 10.4.”
- Finally, the court noted that “even plaintiffs did not view the LLC as having been dissolved at any time” in the 11 years separating the member’s death and the litigation. The court pointed to the fact that, after a second member died in 2008, the plaintiffs along with other members purchased the deceased member’s interest, “strongly suggest[ing] that they believed that the LLC could simply continue . . . if no contrary steps were taken by Members.” The court also noted the absence of any evidence “that plaintiffs believed that the LLC was winding up at the time they bought the second, deceased member’s interest.”
Illiquidity + Death Watch = Litigation
There is little appetite in the public market to acquire minority, non-controlling interests in closely held companies that have no prospect of going public and no assurance of regular distributions.
Unless a minority member desires and is allowed to transfer his or her membership interest to a family member or to a family trust either during or after his or her lifetime, the LLC agreement effectively becomes a death watch. By that I mean, the members who can outlast their co-members not only may gain greater management control, but also greater leverage to command a lower purchase price for the deceased member’s interest. From my perusal of the record in Sternlicht, it appears that all the individual members of the LLC are elderly.
The surviving members’ enhanced bargaining power stems in part from the default rules found in most LLC statutes. The default rules diminish the deceased’s membership status to that of a so-called “bare naked assignee” in the hands of an estate representative or the transferee of the interest by inheritance, with no voting rights and no legal standing to demand access to books and records, assert derivative claims, or sue for judicial dissolution.
The Sternlicht case, like many others of its ilk, is the predictable result of LLC agreements that lack buy-sell provisions assuring non-controlling members a means of selling their interest during their lifetime at a reasonable price on reasonable terms. It is no accident, as in the Rubin case discussed in last week’s post, that the plaintiffs in the Sternlicht case sued only after an unsuccessful attempt to negotiate a voluntary buy-out.
A well-designed buy-sell agreement is one that allows continuation of the business with minimal (or at least tolerable) economic disruption while allowing departing owners to liquidate their interest at a fair appraised value or pursuant to a reasonable formula. And, of course, the optimal and likely last best chance to devise a fair buy-sell agreement is at the outset of the venture, when no one knows for sure whether ultimately they’ll be a buyer or a seller.