Buyers of fine art must investigate the work’s provenance before closing the deal. The same holds true for anyone contemplating the acquisition by assignment of a membership interest in a limited liability company.

Not only must the assignee-to-be determine the provenance of the assignor’s membership interest, the LLC’s operating agreement also must be consulted for restrictions on transfer rights and, assuming transfer is permitted, whether an assignment conveys full membership rights or an economic interest only.

These lessons were learned painfully and too late to help the plaintiff in Behrend v New Windsor Group, LLC, in which an appellate court last month affirmed dismissal of the putative assignee’s lawsuit claiming a 50% membership interest in an LLC that owns a shopping center in Orange County, New York, allegedly acquired by assignment from someone who, as it turned out, held a contingent interest that never ripened into membership.

A Contingent Membership Interest Goes Bust

The LLC was formed by defendant Andrew Perkal in 2004 to acquire and operate a shopping center in New Windsor, New York. The operating agreement, never amended, named defendant Andrew Perkal and his wife as the sole members. It included a provision requiring prior unanimous consent of the other members to any member’s proposed transfer of his or her membership interest.

When the shopping center was acquired, Perkal entered into an agreement with Joseph Klein — named as a defendant but who never appeared in the action — under which Perkal loaned Klein $650,000, Klein personally guaranteed the LLC’s purchase money mortgage on the shopping center, Klein undertook sole responsibility to pay down the mortgage loan, and upon Klein’s repayment of the $650,000 loan and satisfaction of the mortgage, he would become a 50% member.

In 2008, upon Klein’s failure to repay the $650,000 loan and satisfy the mortgage, he and Perkal agreed to submit to arbitration before a Jewish Rabbinical Court. In 2009, the arbitrators determined that Klein held only a prospective interest in the LLC and ordered him to repay the loan and satisfy the mortgage within 30 days. They further ordered that if Klein did so, he would own a 50% membership interest in the LLC, and if he defaulted, he must “transfer or cause to be transferred any and all interests he has or may have” in the LLC or its property to Perkal within 10 days of default.

Klein defaulted. In 2010, Perkal obtained a state court judgment confirming the arbitration award and ordering Klein to transfer “any and all interests” he has in the LLC or its property to Perkal. In 2012, following contempt proceedings against him, Klein finally executed the documents in compliance with the judgment.

At no point in the arbitration or court proceedings did Klein allege or disclose that he had entered into an agreement with anyone else transferring or encumbering his prospective membership interest in the LLC.

Up Pops a Putative Assignee of Klein

Shortly after Klein delivered the court-ordered documents in 2012, plaintiff Julius Behrend served a complaint primarily seeking a declaration that he holds a 50% membership interest in the LLC acquired from Klein pursuant to a Memorandum of Understanding dated December 31, 2007. It was undisputed that, prior to the 2012 lawsuit, Behrend never contacted Perkal or claimed that Klein had transferred to him Klein’s interest in the LLC.

The MOU is hardly a model of draftsmanship. Its recitals state that Klein owes Behrend approximately $2.3 million and that “to secure” the debt Klein wishes to “transfer” to Behrend “his ownership interest” in a number of “Real Estate entities” including the LLC. Article Fifth states that Klein “hereby transfers and conveys” to Klein “all his interest in [the LLC], where he owns 50%.” Subsequent Articles grant Klein a 24-month “option” to “redeem and buy back” his LLC interest upon payment of the $2.3 million; state that if Klein doesn’t exercise the option, his interest in the LLC “shall be considered an additional security on the outstanding debt” owed to Behrend; and state that Behrend does not accept the transfer of interests “in lieu of the outstanding [$2.3 million] balance, but is purely accepting them as an additional security on the outstanding debt.”

It was undisputed that, prior to filing his 2012 lawsuit, Behrend gave no notice to the LLC and made no effort to publicly file or otherwise record any grant of a security interest or any transfer of membership interest in the LLC. As he later admitted at his deposition, Behrend never made due diligence efforts to ascertain whether Klein held a valid membership interest in the LLC.

In 2016, the lower court found that Behrend failed to establish that Klein had transferred his interest in the LLC to Behrend and that, at most, Klein had transferred only a security interest that never was perfected. The court also determined that Behrend could have no interest in the LLC’s property, as a member of an LLC has no interest in specific property of the LLC under LLC Law § 601. It also found that it was unnecessary to determine any questions of fact concerning what, if any, membership interest Klein previously held in the LLC, as the evidence established that no assignment of membership occurred in conformance with the LLC’s operating agreement, and Klein had transferred whatever interest he held in the LLC to Perkal pursuant to court order in 2012.

The Appeal

Behrend appealed the lower court’s order dismissing his lawsuit. Behrend’s appellate brief argued that the MOU in Article Fifth unambiguously evidenced Klein’s conveyance of his membership interest in the LLC; that the other provisions referencing a security interest were independent of the grant of the interest; and that any possible ambiguity arising from the MOU’s other provisions must be resolved in Behrend’s favor. Behrend also argued that, under provisions of the Uniform Commercial Code, even if Klein conveyed to Behrend a security interest only, and even if Behrend never perfected his security interest, it took priority and defeated Klein’s transfer of his interest in 2012.

Perkal’s and the LLC’s appellate brief primarily argued that Klein never obtained a membership interest in the LLC and therefore could not convey to Behrend a membership interest he did not own. Rather, they argued that Klein at most had a non-transferable “unvested capital interest” in the LLC that lapsed when Klein defaulted on his loan and mortgage repayment obligations, leading to the arbitration award and court judgment. The brief defended, as consistent with such unvested interest, the LLC’s issuance of Form K-1s to Klein through 2011 when the returns reflected the “zero-ing out” of his interest pursuant to the arbitration award.

Last month’s ruling by the Appellate Division, Second Department, affirmed the lower court’s ruling in all respects. First, it focused on the operating agreement’s transfer restrictions as a bar to any conveyance to Klein, stating:

Here, [the LLC’s] operating agreement allows for the transfer of membership interest, but “only with the prior unanimous consent of the other Members either in writing or at a meeting called for such purpose.” The operating agreement further provides that if the other members do not approve of the transfer, then the transferee shall have no right to become a member. In support of their cross motion, [Perkal and the LLC] submitted evidence that there had not been any prior unanimous consent allowing for the transfer of any membership interest to [Behrend]. In opposition to the cross motion, [Behrend] failed to raise a triable issue of fact on this issue.

Second, even assuming there were questions of fact concerning “whether the 2007 ‘memorandum of understanding’ embodies an intent to transfer such a membership interest, or only a security interest,” under the LLC Law’s default rules Behrend at most would have received an economic interest, not a membership interest. As the court explained:

In addition to establishing that [Behrend] had not become a member of [the LLC], [Perkal and the LLC] established that any interest Klein might have held in [the LLC] was extinguished as of April 26, 2012, when he transferred that interest to Perkal and resigned as a member. Thus, to the extent that Klein purportedly assigned his membership interest to [Behrend], the only effect of such an assignment would be that [Behrend] was entitled to receive the distributions and allocations of profits and losses to which Klein would have been entitled from December 31, 2007, to April 26, 2012.

Diligence is a Must

According to Behrend’s brief, after Klein was served with Behrend’s complaint he fled the country for Israel, apparently leaving Behrend holding an empty bag for some or all of the $2.3 million he loaned Klein.

There are some obvious questions that the available court papers don’t answer. Did Klein know of the operating agreement’s membership interest transfer restrictions when he made his agreement with Perkal in 2004? Did he know of them when he made his 2007 agreement with Behrend? Behrend believed Klein held at most a 50% membership interest at the time of the 2007 MOU. Did he know or even ask who held the other 50% interest? Why didn’t he insist on getting the operating agreement before entering into the MOU? Why didn’t he reach out to Perkal before 2012, and certainly after 2009 upon the termination of Klein’s redemption option?

It’s hard to judge from the form and content of the MOU whether a lawyer’s hand was involved in its drafting. I prefer to think it wasn’t, because if it was, the lawyer created a riddle, wrapped in a mystery, inside an enigma, as to whether the parties intended to create a security interest, a present transfer of an LLC interest, a future transfer of an LLC interest, or even what kind of interest was being transferred.

If a lawyer wasn’t involved, then blame shifts to the principals for not having the wisdom to get a qualified lawyer involved, one who would have known the absolute necessity to obtain the LLC’s operating agreement to determine the LLC’s ownership and the transferability of LLC interests regardless whether the contemplated agreement called for a conveyance of the interest outright or upon foreclosure of a security interest. A qualified lawyer for the potential assignee of an interest also would have trained his or her eyes on the operating agreement’s provisions concerning management, voting, capital contributions, expulsion, distributions, amendment of the operating agreement, and a number of other important rights and obligations attendant to the proposed LLC interest.

A tip of the hat to attorney David M. Berger, who represented Perkal and the LLC, for providing copies of the appellate briefs.