“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

In 2008, Vice Chancellor J. Travis Laster of the Delaware Court of Chancery — one of the many intellectual giants and gifted writers who’ve occupied seats on that bench — published an article in the Delaware Journal of Corporate Law entitled Goodbye to the Contemporaneous Ownership Requirement.  The article argued that the contemporaneous ownership rule in shareholder derivative actions, embodied in DGCL Section 327 (“In any derivative suit instituted by a stockholder of a corporation, it shall be averred in the complaint that the plaintiff was a stockholder of the corporation at the time of the transaction of which such stockholder complains or that such stockholder’s stock thereafter devolved upon such stockholder by operation of law”) and likewise in New York’s BCL Section 626 (b), should be abolished as “unnecessary,” “incoherent,” “ill-suited to each of the purposes advanced to support it,” and “arbitrarily mandat[ing] the dismissal of potentially meritorious claims.”

At the risk of vastly over-simplifying VC Laster’s multi-pronged argument, the central point he made is that, as long as the derivative plaintiff is a shareholder upon commencing the action and for its duration, it’s meaningless whether the plaintiff owned shares at the time of the challenged corporate action because the claim belongs to the corporation and is being brought for the benefit of the corporation, not the shareholder.

In one of his subsequent opinions questioning the rule’s wisdom, Bamford v Penfold, L.P., VC Laster dropped an intriguing footnote referring to a “provocative article” published in 2010 by Professor of Law Lawrence Mitchell of The George Washington University entitled Gentleman’s Agreement: The Anti-Semitic Origins of Restrictions on Stockholder Litigation (available here).  As the title suggests, Professor Mitchell’s thesis is that the statutory contemporaneous ownership rule and other restrictions on derivative actions including the security requirement for small shareholders, first enacted in New York in 1944 and in Delaware the following year, were promoted by the non-Jewish, corporate defense bar dominated by white-shoe law firms to stymie shareholder suits being brought by predominantly Jewish lawyers.  From the footnote:

In 1944, the New York legislature adopted a suite of statutory limitations on derivative actions that included a security-for-expenses requirement and a contemporaneous ownership requirement. Professor Mitchell has argued that the legislation was influenced by the anti-Semitic prejudices of the predominantly non-Jewish defense bar and their reaction to the perceived prevalence with which predominantly Jewish lawyers represented plaintiffs in stockholder derivative actions challenging the corporate establishment. The New York initiative had widespread influence, as “[p]assage of the New York statute inspired a burst of heated attacks on the derivative suit as an abusive and corrupt device from supporters of business interests throughout the country.” Donna I. Dennis, Contrivance and Collusion: The Corporate Origins of Shareholder Derivative Litigation in the United States, 67 Rutgers U. L. Rev. 1479, 1520 (2015). Delaware notably did not adopt a security-for-expenses statute, but it seems likely that the 1945 enactment of Section 327 was spurred by the New York initiative.

Whatever its origins, VC Laster’s advocacy seeking to eliminate the contemporaneous ownership rule has not spurred its repeal by the Delaware legislature, hence Section 327 remains on the books.  Which brings me to an interesting opinion handed down last week by Chancellor Kathaleen St. J. McCormick in SDF Funding LLC v Fry in which, after remarking that Section 327’s contemporaneous ownership requirement “is not universally beloved” and referring to VC Laster’s scholarship on the issue, she considered and ultimately rejected the argument of a putative derivative plaintiff who ran afoul of the rule, that he should be afforded “equitable standing” to prosecute the action.

Continue Reading Equitable Standing in Shareholder Derivative Suit Bows to the Contemporaneous Ownership Rule

If you ask me to name the most common skirmishes over the adequacy of pleadings at the outset of business divorce litigation, at or near the top of the list are motions to dismiss a dissident owner’s direct claims that should have been brought derivatively, or derivative claims that should have been brought directly, or claims pleaded as both direct and derivative.

The frequency of such motion practice contrasts with the simplicity of the two-factor test devised by the courts for determining whether a claim is direct or derivative. As stated by the Appellate Division, First Department in Yudell v Gilbert, borrowing from the Delaware Supreme Court’s Tooley formulation, the determination depends on “(1) who suffered the alleged harm (the corporation or the stockholders); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders individually).”

The test sounds easy to apply, and in most cases it is, especially when the alleged wrongful conduct by a controller involves misuse or waste of company funds or other financial impropriety that affects the nonculpable owners indirectly and on a shared basis by devaluing their equity interests. While the nonculpable owners of a closely held business may be victimized in a very real sense by the controller’s alleged misconduct, the direct injury is to the company for which the company is entitled to any recovery. Stated differently, the claim is company property, the prosecution of which normally depends on the business judgment of those holding the company’s managerial reins, and therefore can only be asserted by the non-managerial owners as a derivative claim after making demand upon the company managers or establishing that demand would be futile.

Let’s look at some recent examples of derivative and direct claims that went astray. Continue Reading Singin’ the Derivative Plaintiff Blues

BCL 626 governs shareholder derivative actions, or suits brought by individual shareholders on behalf of, and for injury to, the corporation. Subsection (e) provides that if the plaintiff—the individual shareholder asserting the right of the corporation—is successful in recovering anything of value for the corporation, the court in its discretion may award reasonable expenses, including attorney’s fees, to be paid from the award to the corporation.

While BCL 626(e) sets forth the fee-sharing framework in derivative actions brought in the name of a corporation, and New York’s Revised Limited Partnership Law section 121-1002(e) mirrors the BCL and applies to partnerships, there is no corresponding fee-sharing statute for derivative suits commenced and litigated on behalf of other entities, such as LLCs. Without a statutory analogue, is the same fee-sharing framework available?

I have not yet seen a case squarely addressing the issue, but the First Department’s recent decision in Bd. of Managers of 28 Cliff St. Condominium v Maguire, 2020 NY Slip Op 06844 [1st Dept Nov. 19, 2020] may open the door for a successful LLC-member derivative plaintiff to argue that the common law includes the right to recover fees from any award rendered in favor of the LLC.

Continue Reading Fee Sharing in LLC Derivative Suits: A Common Law Right and a One Way Street 

  • If a written limited partnership agreement contains detailed provisions governing partner withdrawal and dissolution, can a court nonetheless look to the statutory “default rules” in the Revised Limited Partnership Act (the “RLPA”) to supply additional grounds for withdrawal and dissolution not found in the contract?
  • Under RLPA, is the filing by a limited partner of a petition to dissolve the limited partnership enough, on its own, to automatically dissolve the entity without regard to the merits of whether the entity should, or ought to be, dissolved?
  • Under RLPA, is an order appointing a receiver of a limited partnership enough, on its own, to automatically dissolve the limited partnership?

A recent decision from Manhattan Commercial Division Justice Andrew Borrok, Weinstein v RAS Prop. Mgmt. LLC, Decision and Order [Sup Ct, NY County Oct. 23, 2020], rendered first-impression holdings on each of these issues, raising important questions about the interplay between contractual and statutory withdrawal and dissolution principles for New York limited partnerships, the outcome of which may have enormous impact upon owners of New York limited partnerships. Continue Reading Limited Partnerships and the Self-Fulfilling Dissolution Petition

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”