“A plaintiff asserting a derivative claim seeks to recover for injury to the business entity. A plaintiff asserting a direct claim seeks redress for injury to him or herself individually. Sometimes whether the nature of the claim is direct or derivative is not readily apparent.”

The preceding quotation, from a signed opinion by Justice Karla Moskowitz (pictured) writing for a unanimous panel of the Appellate Division, First Department, in Yudell v. Gilbert, 2012 NY Slip Op 05896 (1st Dept Aug. 7, 2012), captures the essence of a thorny issue that can arise in lawsuits brought by shareholders, LLC members and partners asserting fiduciary breach and other claims against controlling persons of the business entities and sometimes against persons outside the entity.

There are, as Justice Moskowitz also observed, a number of standard scenarios — e.g., involving shareholders who suffer solely through depreciation in the value of their stock, or who allege mismanagement or diversion of corporate assets and opportunities — which clearly fall in the category of derivative claims. At the other end of the spectrum are claims clearly identifiable as direct claims seeking individual redress, such as discriminatory shareholder distributions. But in the middle is an endless supply of unique fact patterns where the line separating direct from derivative can get blurry.

Why does it matter? For one, derivative claims belong to the business entity, which is why there exist both statutory and common law rules requiring a plaintiff suing derivatively to allege in the complaint with particularity the plaintiff’s pre-suit efforts to secure initiation of the action by the controlling board or other governing body, or that doing so would have been futile. For another, there are situations where a plaintiff may have standing to litigate direct but not derivative claims, such as following a freeze-out merger. The recharacterization of a direct claim as derivative therefore may be fatal to a complaint that either does not allege at all, or does not allege adequately, pre-suit demand or demand futility.

Continue Reading Appellate Decision in Partnership Dispute Clarifies Distinction Between Direct and Derivative Claims

With apologies to the King James Bible, what the Manhattan real estate market giveth, a poorly conceived partnership agreement taketh away.

It’s the best explanation I can offer for three successive lawsuits lasting almost fifteen years and counting between two partners in a general partnership that owns a full-floor unit in a commercial co-op building in Manhattan’s Garment District and, since the death of one of the partners in 2011, between the deceased partner’s estate and the surviving partner.

The partnership, known as S-L Properties, acquired the unit in 1984. Its two partners, Robert Liss and Sage Systems, Inc., held 43.07% and 56.93% partnership interests, respectively. Under their agreement, the partners each took assigned portions of the unit for the use of their two, separate businesses. From what I can tell, the purchase price was around $250,000. For anyone familiar with Manhattan real estate values, that tells you right away that, whatever was paid for the unit in 1984, its value grew exponentially by the time litigation broke out in 2006, and super-exponentially at current market values.  That’s the “giveth” part.

The partnership had a 40-year fixed term under its written partnership agreement, subject to early termination in the event of a partner’s death, upon which the surviving partner has an option to purchase the deceased partner’s interest for a fixed price essentially equal to the decedent’s cash contributions plus 6% interest from the date of each contribution. That’s the “taketh away” part.

The litigation unfolded in three acts:

  • In Act One, Liss sought judicial dissolution of the partnership and liquidation of the partnership’s realty asset for Sage’s alleged violations of the proprietary lease’s subletting provisions.
  • In Act Two, Liss filed a second lawsuit against Sage for an accounting. Following Liss’s death, Sage filed an amended countersuit to compel a buy-out of the Liss estate’s partnership interest at the fixed price under the partnership agreement.
  • In Act Three, Sage sued Liss for contractual indemnification of its legal expenses defending the dissolution lawsuit.

Intrigued? Read on to find out what happened. Continue Reading A Partnership Dissolution in Three Acts Over Fifteen Years and Counting

I’ve yet to see him make a court appearance, and hope I never do, but the Grim Reaper sure has a knack for disrupting business divorce litigation involving LLCs and limited partnerships.

To begin with, the statutory default rules for New York limited partnerships and limited liability companies essentially are the same for transfer of ownership interests and rights of the estate of a deceased partner or member. This is no coincidence. Many provisions in the LLC Law enacted in 1994 are modeled on the Revised Limited Partnership Act (RLPA) enacted several years earlier.

Death. Under the default rules governing the estate’s rights upon the death of a partner in a limited partnership or an LLC member (RLPA § 121-706; LLC Law § 608), the decedent’s executor or other legal representative may exercise all of the partner’s/member’s rights “for the purpose of settling his or her estate or administering his or her property,” including  any power under the partnership or operating agreement of an assignee to become a limited partner or member.

Assignment. Unlike shares in corporations, which generally are freely transferable and convey the entire package of economic, voting, and other rights associated with the shares, and except as otherwise provided by agreement, the assignment of LP and LLC interests conveys only the assignor’s rights to receive distributions and profit/loss allocation (RLPA § 121-702LLC Law § 603). The assignee can become a partner or member only if the partnership or operating agreement so provides, or if the other partners or members give their consent (RLPA § 121-704; LLC Law § 604).

When the Grim Reaper strikes, the combined effect of the default rules can block an estate representative from commencing a derivative action against the entity’s controllers, or from stepping into the shoes of a decedent in a pending suit brought by the decedent while alive. The same holds true for actions seeking judicial dissolution and to inspect books and records, both of which statutorily condition standing on the petitioner being a partner or member.

This blog previously featured the Budis v Skoutelas and Pappas v 38-40 LLC cases in which courts held that the express terms of operating agreements, providing that the “successor in interest” of a deceased LLC member shall succeed to the decedent’s economic rights but shall not acquire member status, deprived the decedents’ executors of standing to bring derivative actions against the LLC’s controlling members.

A first-impression decision last week by Manhattan Commercial Division Justice Andrew Borrok in Weinstein v RAS Property Management, LLC, 2020 NY Slip Op 20028 [Sup Ct NY County Feb. 5, 2020], makes it official: estate representatives of deceased limited partners get the same treatment. Continue Reading Death of Limited Partner Disarms Derivative Action

What makes someone a member of an LLC?

It’s a question that frequently arises in business divorce cases involving LLCs that have no written operating agreement much less certificated membership interests. On the answer hangs the fate of the complainant’s standing to seek judicial dissolution, or to demand access to LLC books and records, or to assert derivative claims, or to enforce any other rights arising from member status.

It’s also a question the answer to which turns on an endless array of case-specific facts and circumstances, which may be why I haven’t seen any New York case law purporting to establish a uniform test for establishing one’s undocumented membership in an LLC.

In a recent decision by a Brooklyn judge involving a petition for judicial dissolution of an LLC, however, the court borrowed from partnership law its multi-factor test for determining the existence of a partnership in concluding that the petitioner was not a member of the subject LLC and therefore lacked standing to seek dissolution.

The case is Matter of Shiel (CoolFrames, LLC), in which I represented the prevailing company and the respondent members.

Continue Reading Court Looks to Partnership Law in Ruling Against Petitioner’s Status as LLC Member

In business divorce litigation, petitioners / plaintiffs often want to start the case with a bang. A common tactic is to file a petition / complaint simultaneously with an injunction motion. Often there is a real need for an injunction – the respondent / defendant may be engaging in activities that could cause real, irreparable harm.

But often another objective is that if the injunction motion succeeds, it will be an early win in the case, set the stage favorably for the litigation to come, put significant leverage on the respondent / defendant by restricting its freedom to operate the business, and possibly result in a speedier resolution of the case. If the injunction motion or complaint itself has vulnerabilities, however, a case meant to start with a bang may end with an unceremonious whimper. That is just one lesson from a recent decision by Manhattan Commercial Division Justice Saliann Scarpulla in Pappas v 38-40 LLC, 2018 NY Slip Op 30329(U) [Sup Ct NY County Feb. 22, 2018]). Continue Reading Operating Agreement Dooms Derivative Claims by Deceased LLC Member’s Estate

Almost always there are elements of acrimony and intense emotion in litigation between co-owners of closely held business entities. The degree of toxicity can vary widely from case to case, although it tends to show up more conspicuously in litigation involving family-owned ventures.

Claims by non-controlling shareholders accusing controlling shareholders and directors of financial or other managerial abuses frequently are styled as derivative claims seeking recovery on the corporation’s behalf for harm to the corporation. In such suits, under the right circumstances the accused may challenge the accuser’s standing to pursue derivative claims based on conflict of interest.

Conflict of interest usually entails some tangible pecuniary interest held or asserted as a direct claim by the accuser that is adverse to the corporation or otherwise at odds with the claims asserted on behalf of the corporation. But a number of court decisions in New York also have cited as a factor in the analysis the accuser’s “animus” or “retaliatory” motive directed against the accused. The legal theory, akin to that applied in class actions, is that the accuser’s personal hostility and the resulting acrimony undermine the accuser’s ability to fairly and adequately represent the interests of the shareholders and the corporation.

Last year I posted about the decision in Pokoik v Norsel Realties in which a trial judge dismissed for lack of standing derivative claims brought by individuals holding an aggregate 11% interest in a realty-holding limited partnership. Among the reasons cited by the judge was that the plaintiffs “failed to demonstrate on this record that they are free from personal animus” as evidenced by the lead plaintiff’s “litigious nature” including several prior lawsuits against the defendants (including family members) alleging similar mismanagement claims, leading the court to conclude that the lawsuit was being wielded by the plaintiffs as “‘a weapon in the total arsenal’ so as to gain leverage in the other disputes.”

If, based on that decision, anyone thought freedom from personal animus is now part of the required showing by a derivative plaintiff, think again. Last week, the Manhattan-based Appellate Division, First Department, reversed the lower court’s decision and reinstated the derivative claims against some (but not all) of the named defendants. Continue Reading Appeals Court Reinstates Derivative Claims Dismissed for Conflict of Interest Where Parties’ Relationship Not “Especially Acrimonious”

litigiousThe U.S. reportedly has the world’s highest number of lawyers per capita (1 for every 300 people) and the 5th highest number of lawsuits per capita (74.5 for every 1,000 people, topped only by Germany, Sweden, Israel, and Austria).

If, as it appears, litigation has become a national pastime in the U.S., then why, when we describe someone as having a “litigious nature,” does that label carry such opprobrium? Is there an unspoken assumption that anyone who brings a multitude of lawsuits must not have meritorious claims, or has ulterior motives to sue? Then again, we recently awarded the presidency to someone who, according to a USA Today analysis, has sued or been sued in 3,500 cases over the last 3 decades.

These observations are spurred by a recent court decision in Pokoik v Norsel Realties, 2017 NY Slip Op 50459(U) [Sup Ct NY County Apr. 12, 2017], in which Manhattan Commercial Division Justice Jeffrey K. Oing cited the plaintiff’s “litigious nature” among the factors supporting dismissal of his derivative lawsuit brought against the fellow members of a real estate partnership, some of whom are relatives of the plaintiff, Leon Pokoik. Granted, it was not cited as the primary factor, but it’s one of those atmospheric factors in a litigation whose impact is hard to measure. Continue Reading Suing on Behalf of People You’re Suing Can Sink a Derivative Lawsuit — Especially If You Have a Litigious Nature

The derivative lawsuit is commonly defined as a lawsuit brought by a shareholder of a corporation against the directors, management, or controlling shareholders of the corporation seeking recovery on the corporation’s behalf for breach of duty involving self-dealing, looting, waste or other wrongful conduct causing injury to the corporation. Derivative lawsuits also can be brought on behalf of alternative entities, including limited partnerships (LP) and limited liability companies (LLC).

Since the claims belong to the corporation (or LP or LLC) the governing statutes and decisional law, applicable to public and private companies alike, impose standing criteria for would-be derivative plaintiffs, including the contemporaneous and continuous ownership requirements. In addition, the claim’s proponent must plead and prove either (a) the making of a pre-suit demand upon the corporation’s directors to bring the suit directly in the corporation’s name and right or (b) that such demand would have been futile and therefore is excused. Litigation over the plaintiff’s satisfaction of the demand requirement more often than not centers on demand futility.

Because many New York-based businesses are formed in Delaware, and because the ability to seek judicial dissolution of a Delaware entity in a New York court is virtually non-existent, when litigation among co-owners of privately-owned Delaware entities takes place in New York, such cases typically feature derivative claims, the standing requirements for which are governed by Delaware law including a large and well-developed body of Delaware case law concerning demand futility.

In the last two months, the Manhattan-based Appellate Division, First Department, handed down three decisions in derivative lawsuits examining challenges to satisfaction of the demand futility requirement: one involving a Delaware corporation, another involving Delaware LPs and LLCs, and the third involving a New York LLC. While none of them addresses claims seeking judicial dissolution, it is the exceptional dissolution petition that doesn’t include a derivative claim against the other owner alleging misappropriation of company assets or business opportunity. It’s therefore important for business divorce practitioners to stay current on the state of the law concerning the standing requirements for derivative claims. Continue Reading Recent Appellate Rulings Address Demand Futility in Derivative Lawsuits

One of the most frequently encountered preliminary skirmishes in shareholder litigation involving closely held business entities focuses on whether the plaintiff’s claims are properly classified and brought either as direct claims for individual relief or as derivative claims for recovery on behalf of the entity. This duality — direct or derivative — has major consequences at the pleading stage and beyond.

Yet, as the Appellate Division, First Department, recently observed in Yudell v. Gilbert, where it expressly adopted Delaware’s formulation for distinguishing between the two based primarily on who suffers the alleged harm, “[s]ometimes whether the nature of the claim is direct or derivative is not readily apparent.”

The line between direct and derivative gets especially blurry when the only two shareholders involved are the aggrieved plaintiff and the defendant whose alleged misconduct results in the wholesale transfer of the corporation’s assets to the defendant or the defendant’s affiliate. Such cases may give rise to direct claims that, in other contexts, might be classified as derivative.

Take, for example, the case of Barmash v. Perlman, 2013 NY Slip Op 31518(U) (Sup Ct NY County July 3, 2013), decided earlier this month by Manhattan Commercial Division Justice Melvin L. Schweitzer. In Barmash, Justice Schweitzer denied a motion to dismiss a complaint brought by a minority shareholder where the claimed breaches by the controlling shareholder, constituting what the court labeled the “de facto liquidation” of the corporation, resulted in harm to the corporation to be pursued derivatively, but also caused injury “uniquely and individually” to the plaintiff minority shareholder permitting direct recovery.  Continue Reading Minority Shareholder’s De Facto Liquidation Claim: Direct, Derivative, or Both?

Note to Readers:

This month marks the 5th anniversary of the New York Business Divorce blog. Every Monday morning, without fail for five years, I’ve posted a new article highlighting a new court decision or other development of interest to lawyers, business owners, business appraisers, and anyone else concerned with broken relationships among owners of closely held business entities.

When I started the blog, my greatest fear was running out of things to write about. After five years of blogging, I can say with great confidence that, the human condition and human relations being what they are, there is an endless stream of business partners falling out of love and into court. Of course, I’m also very grateful to the many judges in New York who take the time and care to write informative decisions in cases involving dissolution and other disputes among business partners.

The most rewarding part of blogging has been the many new relationships it’s led to over the last five years with business owners, other lawyers, other bloggers, accountants, appraisers, and academics. I’ve learned from them that education can be a wonderful, two-way street.

I appreciate the feedback I get from readers. If you’d like to share thoughts about anything I write about, please post a comment, it’s quick and easy to do. If you’re a lawyer (or a judge!) with an unpublished decision that might be of interest to other readers, send it to me. If there’s anything else you’d like me to write about, let me know.

And now, let’s start the next five years.

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I doubt Mark Twain had litigation in mind when he offered the advice, “Always tell the truth. That way, you don’t have to remember what you said.” For litigants, though, failing to remember or, worse yet, negating what was said in a prior lawsuit can have drastic consequences when a judge in a subsequent lawsuit concludes that the same litigant, having succeeded in the prior case by taking one position, is now taking a contrary position simply because his interests have changed.

I’ve previously written several posts on shareholder disputes in which, as it’s known, the doctrine of judicial estoppel against inconsistent positions has been raised successfully as a defense to a corporate dissolution petition or other shareholder suit:

  • In Light v. Boussi (read here), Justice Carolyn Demarest invoked judicial estoppel to dismiss a dissolution petition by a putative 50% shareholder who failed to disclose his alleged stock ownership in his prior bankruptcy proceeding.
  • In Glatzer v. Webster (read here), also decided by Justice Demarest, the court applied judicial estoppel to defeat a claim of ownership in an LLC by an ex-spouse who, in prior divorce proceedings, disclaimed an ownership interest.
  • In Watkins v. J C Land Development, Ltd. (read here), Justice Emily Pines dismissed a shareholder derivative action by a putative 50% shareholder who, in prior federal sentencing proceedings, failed to disclose his alleged stock holding.

The Rubio Lawsuit

Justice Pines had another opportunity to apply judicial estoppel in her decision last month in Rubio v. Rubio, 2012 NY Slip Op 52218(U) (Sup Ct Suffolk County Nov. 26, 2012), involving a shareholder dispute over a family-owned auto dealership. In Rubio, it was the plaintiff’s inconsistent disavowal of a stock ownership interest in prior litigation with his ex-wife that proved fatal to his shareholder derivative claims against his brother and others in the suit before Justice Pines. Continue Reading Court Dismisses Shareholder Derivative Action Due to Inconsistent Stock Ownership Claim in Prior Lawsuit