The proverb “All for the want of a horseshoe nail” aptly describes the possibly mortal blow dealt by the Appellate Division’s recent decision in Favourite Ltd. v Cico, 2020 NY Slip Op 01463 [1st Dept Mar. 3, 2020], to a lawsuit initiated by non-managing members of a manager-managed Delaware LLC whose certificate of formation was cancelled for the ministerial failure to designate a new registered agent within 30 days after its old one resigned.
Favourite involves the alleged mismanagement of a Delaware LLC by its former managing members in connection with the financing, operation, and sale of a Manhattan residential apartment building acquired by the LLC to provide short-term rentals for international leisure and corporate travelers. The business was decimated in 2012 by anti-Airbnb legislation, leading to a mortgage default, foreclosure action, and distress sale. The managers used the net sale proceeds as a down payment made by a newly formed LLC to purchase another building, but the purchase never materialized.
In 2015, non-managing members holding more than 50% of the membership interests, as permitted by the operating agreement, voted to remove the managers and then brought suit against them. The suit initially named the LLC (along with some of the non-managing members) as plaintiff but it was dropped in the first amended complaint after losing its legal representation.
The LLC’s Cancellation
In late 2016, the Delaware Secretary of State’s office cancelled the LLC’s certificate of formation for failure to designate a new registered agent. Over a year later, in April 2018, one of the plaintiff members, signing as an “Authorized Person,” filed with the Secretary of State a Certificate of Revival and obtained a Certificate of Good Standing. Some two months later, a majority-in-interest of the members voted to authorize the LLC to prosecute claims against the former managing members.
- Why, you ask, was the Certificate of Revival not signed by an LLC manager when the operating agreement clearly disabled non-managing members from acting on the LLC’s behalf? Because it had no manager after the defendant managing members were removed.
- Why, you ask, did the LLC not have a new manager? Because the LLC’s operating agreement required a 75% vote of the membership interests to replace a removed manager.
- Why, you ask, were the members unable to obtain 75% of the voting interests to appoint a new manager? Because the removed managing members held more than a 25% interest and had no incentive to consent to the appointment of a new manager to prosecute the lawsuit against them in the LLC’s name.
- Why, you ask, would non-managing members enter into an intrinsically dysfunctional operating agreement allowing a bare majority of the members to remove a manager but requiring a 75% super-majority to replace managers holding more than 25%? I haven’t a clue. It’s also worth noting that the operating agreement’s amendment provision states that “[t]his Agreement and the Company’s Articles of Organization may only be amended with the written consent of the Manager and a Majority in Interest of the Members,” thereby blocking amendment as a workaround to the super-majority provision.
After filing the Certificate of Revival, the plaintiffs requested leave to file a second amended complaint adding back the LLC as a named plaintiff and asserting direct claims on its behalf for breach of the operating agreement and breach of fiduciary duty. The defendants opposed on a number of grounds, including that the member who filed the Certificate of Revival lacked authority to do so, and that the Delaware Chancery Court had exclusive subject matter jurisdiction of the claims.
The Lower Court’s Decision
In October 2018, Manhattan Commercial Division Justice Jennifer Schecter issued a decision that I wrote about here, largely granting the motion to amend. Justice Schecter summarily rejected the defendants’ argument based on the Certificate of Revival, holding that the LLC was no longer “inactive” and had standing to assert direct claims. She also rejected defendants’ jurisdictional argument, noting that, with the exception of judicial dissolution claims, New York courts “routinely” adjudicate disputes involving the internal affairs of Delaware entities.
Defendants appealed from Justice Schecter’s ruling. Their appellate brief led with the argument that, in the absence of a choice-of-forum provision in the LLC agreement, the agreement’s Delaware choice-of-law provision, together with Section 18-1001 of the Delaware LLC Act, gave Delaware Chancery Court exclusive jurisdiction to adjudicate what defendants’ characterized as plaintiffs’ derivative claims.
Next, the brief made a two-pronged argument that the LLC lacked standing to sue in its own name, first, because Section 18-803(b) of the Delaware LLC Act requires judicial nullification of the LLC’s certificate of cancellation by the Delaware Chancery Court and, second, even if Section 803 (b) doesn’t apply, the non-managing member who filed the Certificate of Revival had no authority to do so under the terms of the operating agreement.
Plaintiffs’ opposing brief argued that the jurisdictional argument was “moot” because the second amended complaint did not assert derivative claims and that, even if the claims were derivative, Section 18-1001’s grant of jurisdiction to Chancery Court was permissive, not exclusive. Plaintiffs also pointed out, as had Justice Schecter, that there are legions of reported cases in which courts of New York and other states have resolved derivative claims brought on behalf of Delaware LLCs.
As to the first prong of defendants’ standing argument, plaintiffs replied that judicial nullification of the cancellation under Section 803(b) does not apply because the LLC was cancelled, not dissolved. As to the second prong, they argued that upon the removal of the defendant managing members, the LLC became a member-managed LLC under the default provisions of Section 18-402 of the Delaware LLC Act and that a majority of the members had voted to authorize the filing of the Certificate of Revival by one of its members and payment of tax arrears.
Subject Matter Jurisdiction. It should come as no surprise that the appellate court readily dispatched defendants’ jurisdictional argument, stating that “contrary to defendants’ contention, New York courts have subject matter jurisdiction over the amended complaint” and “[t]he fact that the operating agreement of [the LLC] chooses Delaware law is of no moment, since ‘choice of law and choice of forum are altogether separate matters.'” The opinion further noted that “section 18-1001 of the Delaware [LLC Act], which provides that ‘a member or an assignee of a limited liability company interest may bring an action in the Court of Chancery,’ is permissive, not mandatory.”
The LLC’s Capacity or Standing to Sue. This is the point at which four years of hard-fought litigation was lost, as I said at the top of this post, all for want of a horseshoe nail. Or maybe two nails, the first being the non-replacement of the registered agent, which led to the LLC’s administrative cancellation, and the second being the filing of an unauthorized Certificate of Revival, which led to the lawsuit’s dismissal.
Initially, the court agreed with plaintiffs that judicial nullification of the LLC’s cancellation under Section 18-803(b) did not apply since the company was not dissolved. “Therefore,” the court wrote, “the Company could, in theory, be revived under [the revival statute] section 18-1109(a).” “However,” the court continued,
plaintiff Sirio SRL, which obtained the certificate of revival on April 19, 2018 as a member of the Company, lacked authority to act on behalf of the company. The Company’s operating agreement states, “No Member as a Member shall have the right to bind the Company in dealings with third parties. No Member is an agent of the Company solely by virtue of being a member and no Member has authority to act for the Company solely.” Even if the Company has become a member-managed LLC, which we are not deciding, the record contains no decision by more than 50% of the members to revive the Company before April 19, 2018. Plaintiffs rely on the vote to authorize the prosecution of the instant action but that vote was taken between May 31 and June 30, 2018. . . . Thus, the Company may not sue as a direct plaintiff, and the members thereof may not bring derivative claims on its behalf. Since plaintiffs lack standing or capacity, this action should be dismissed.
Does this mean all is lost for the plaintiffs and their $4.75 million investment in the LLC? I don’t know the answer other than to note that the appellate court expressly declined to decide whether the inability to appoint a new manager because of the defendants’ non-consent automatically converted the LLC from manager-managed to member-managed under the Delaware LLC Act’s default rules. If it did, in theory the members holding a bare majority-in-interest could hold a new vote either to ratify the filing done in April 2018 by the one member, or to approve a new filing of a corrected Certificate of Revival assuming its acceptance by the Delaware Secretary of State. Alternatively, the plaintiffs might seek leave to file a third amended complaint limited to derivative claims. We’ll just have to wait and see.