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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

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The distinction between direct and derivative claims pervades business divorce litigation.  Whether a dissident owner’s claim against his or her co-owners is a direct claim (one that the owner can assert in their individual capacity) or a derivative one (one that seeks to redress injury to, and therefore must be asserted on behalf of the business) factors into almost every claim we litigate, and it is one of the most common grounds for a pre-answer motion to dismiss, as this post demonstrates.    

Given the choice, most owners would prefer to assert their claims directly.  Derivative claims beget a host of prerequisites and considerations: has the pre-suit demand requirement been complied with? Can the corporation take the litigation out of a shareholder’s hands by appointing a special litigation committee?  If successful on the claims, what assurances does the shareholder have that the corporation’s recovery will be passed on to the shareholders? 

For that reason, we sometimes see shareholders or LLC members utilize artful pleading strategies to cast their claims as direct ones.  But the Tooley test—the standard, under both Delaware and New York law to determine whether a claim is direct or derivative—is a good one.  By considering (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), Courts and attorneys usually can spot the differences between a direct claim and a derivative one.

A recent decision from the Southern District of New York, Miller v Brightstar Asia, 20-CV-4849 (SDNY Sept 11, 2023) considers a shareholder’s reliance on the implied covenant of good faith and fair dealing inherent in the corporation’s shareholders agreement in an attempt to plead what otherwise would be derivative claims as direct ones.

Continue Reading Derivative into Direct and Waived into Preserved: The Transformative Power of the Implied Covenant of Good Faith and Fair Dealing

Someday, perhaps, I’ll find the comedic inspiration to come up with a joke that begins, “An LLC, a partnership, and a close corporation walk into a bar . . ..” Until then, I’ll have to satisfy myself with writing about an LLC, partnership, and close corporation that walk into a blog, offering the following, short treatments of three recent decisions of interest by New York courts:

  • The first, involving an LLC, features a dispute arising from a somewhat unusual right of first refusal provision in an LLC operating agreement that authorizes an intra-member buyout of membership interests triggered by the receipt of an outside offer to purchase the LLC’s sole realty asset.
  • The second, involving a partnership, addresses whether a partner of a dissolved law firm can seek an accounting of an alleged successor law firm formed without him by his former partners.
  • The third, involving a close corporation, considers whether an alleged oral agreement to grow and manage a karaoke lounge without salary in exchange for a 25% equity interest if the venture became profitable, entitled the manager to 25% of the venture’s value following his ouster.

Court Enforces Right of First Refusal for Purchase of Membership Interests Triggered by Outside Offer for LLC’s Real Property

Last month, Brooklyn Commercial Division Justice Reginald A. Boddie issued a noteworthy Decision and Order in Orange Gowanus LLC v Ben-Yosef involving an action by an LLC member to enforce a right of first refusal to acquire its co-owners’ membership interests upon the LLC’s receipt of an outside offer to purchase the real property owned by the LLC’s wholly-owned subsidiary.

Continue Reading Recent Decisions Enforce LLC Member’s Right of First Refusal, Restrict Partnership Accounting, and Allow Damages Claim for Breach of Oral Shareholders Agreement

Welcome to the 12th annual edition of Summer Shorts. This year’s edition features brief commentary on a handful of recent decisions by New York trial judges and appellate courts in a variety of business divorce cases involving capital calls, recapitalization, dissolution agreements, derivative vs. direct claims, and judicial dissolution. Click on the case names to read the decisions.

“Grammatical Irregularities” Don’t Govern Operating Agreement’s Capital Call Provision 

Chen v 697 Dekalb LLC, 2022 NY Slip Op 32418(U) [Sup Ct Kings County July 18, 2022].  Does an operating agreement’s provision stating that “additional capital contribution may be made at such time and in such amounts as the Members shall determine” require unanimous consent of the LLC’s members, or does majority consent suffice? Brooklyn Commercial Division Justice Leon Ruchelsman found that this and other “grammatical irregularities” in the agreement concerning member consent to assignment and the admission of new members “do not govern the plain meaning of the agreement” in this suit brought by a 25% member seeking judicial dissolution of a realty-holding LLC after the majority members threatened dilution unless he contributed an additional $485,000 on top of his original $300,000 investment.

The decision denies both the defendant majority members’ motion to dismiss the complaint and the plaintiff’s motion for summary judgment granting judicial dissolution, finding a “fundamental disagreement between the parties” precluding a summary determination “whether the initial contribution made by the plaintiff was intended to be the only contribution he needed to make or whether others were necessarily contemplated,” as well as “whether the company maintains the necessary finances to continue and whether it remains viable.”

Oddly, neither the parties’ briefs nor the decision mentions the governing Amended Operating Agreement’s omission of any provision authorizing dilution or other consequences for a member’s failure to make an additional capital contribution, as required by LLC Law § 502(c). The omission arguably takes on even greater weight in view of the capital call provision in the LLC’s original operating agreement, to which the plaintiff is not a signatory, authorizing the managers to make capital calls and allowing contributing members to make up a non-contributing member’s shortfall, thereby triggering adjustment of the members’ percentage ownership interests. Continue Reading Summer Shorts: LLC Dissolution and Other Recent Decisions of Interest

The current issue of The Business Lawyer, a quarterly publication of the ABA’s Business Law Section that rightly bills itself as “the premier business law journal in the country,” features a pair of dueling articles of great interest to scholars, practitioners, and other students of the limited liability company. The articles’ authors, whom I’ve had the good fortune getting to know at annual meetings of the LLC Institute and who have guest posted on this blog (here and here) and spoke on my podcast (here), are among the leading authorities in the country on closely held business entities and, in particular, unincorporated entities including partnerships and LLCs.

I’m speaking of Donald J. Weidner (pictured left), Dean Emeritus and Alumni Centennial Professor at Florida State University College of Law, and Daniel S. Kleinberger (pictured right), Emeritus Professor of Law at Mitchell Hamline School of Law.

Among his many accomplishments outside academia, Dean Weidner is co-author of The Revised Uniform Partnership Act published by Thomson Reuters, was the Reporter for the Revised Uniform Partnership Act (1994), and has written numerous articles on partnerships, limited liability companies, and financial accounting (SSRN author page here).

Professor Kleinberger’s extra-curricular contributions are no less impressive, including co-author of a leading treatise on LLCs published by Warren Gorham & Lamont, Co-Reporter and Principal drafter of statutory text and Official Comments to the Revised Uniform Limited Liability Company Act (2006), and author of a host of articles in law reviews and journals (SSRN author page here).

As any long-time reader of this blog knows, and as I wrote not long ago, one of the more common issues litigated at the outset of business divorce litigation involving LLCs as well as close corporations are motions to dismiss a minority member’s direct claims against managers that should have been brought derivatively under the prevailing Tooley test for direct versus derivative claims. The two articles by Dean Weidner and Professor Kleinberger offer a spirited point and counter-point debate between two schools of thought concerning the ability of LLC members to pursue and obtain effective remedies for misconduct claims against LLC managers, either as direct or derivative claims, and the ability (or not) of conflicted LLC managers to gain control of those claims through appointment of a surrogate Special Litigation Committee (SLC) once the claims are characterized either as direct (no SLC) or derivative (yes SLC). Continue Reading LLCs, Direct vs. Derivative Claims, and Special Litigation Committees: A Lively Debate

The New York Times yesterday published an article entitled Climate Change Enters the Therapy Room discussing persons suffering from “climate anxiety.” As a northeasterner, the frigid, snow-blessed, ground-freezing winter we’re having has eased my own concern after years of abnormally mild winters. Probably short-sighted. Probably irrational. We take solace where we can find it.

Here’s another soul-soothing affirmation of winter: this blog’s annual Winter Case Notes. This year’s edition features four recent decisions by New York courts:

  • rejecting a putative LLC member’s tax estoppel argument raised in opposition to a summary judgment motion declaring its non-membership;
  • denying dismissal of a shareholder’s individual claims pleaded alongside derivative claims arising from the controlling shareholder’s failure to pay company payroll taxes;
  • granting summary judgment upholding the plaintiff’s claimed 49.9% LLC membership as recorded in the operating agreement over the defendant’s objection that the transaction actually was a loan disguised as an LLC interest to sidestep ancient Jewish law proscribing loan interest; and
  • denying summary judgment in a dispute between family members over the ownership of a realty holding corporation featuring allegations of a forged stock certificate.

Court Rejects Tax Estoppel in Dispute Over LLC Ownership

Business divorce litigation frequently involves disputes over a party’s claimed ownership interest in the company, especially when the interest is not certificated or otherwise documented by an agreement among the owners. In such cases involving pass-through tax entities, the company’s Form K-1s issued to the partners typically take center stage, with one side claiming the other is estopped from taking a position in court that contradicts the ownership shown by the K-1s. A recent post on this site by Frank McRoberts explains the two competing strands of New York case law on tax estoppel, one strand holding tax returns are not determinative of ownership status, the other holding they are. As you would expect, the outcome depends on who signed the tax returns and who provided the information in them. Continue Reading Winter Case Notes: Tax Estoppel (Not) to the Rescue and Other Decisions of Interest

winding roadThe Delaware Supreme Court last week refused to rehear its affirmance of Chancery Court’s post-trial decision in a case called Zutrau v Jansing. The Appellate Division of the New York Supreme Court last May affirmed a post-trial decision in a closely related case involving the same parties. The two appellate decisions effectively close out a tenaciously fought, seven-year litigation saga involving a minority shareholder’s largely unsubstantiated, multi-faceted attack on the majority shareholder’s management and financial stewardship of a small, New York-based Delaware corporation specializing in proxy servicing.

The litigation history includes an initial books-and-records proceeding in New York followed by serial suits in New York and Delaware asserting a variety of claims for unlawful termination of the minority shareholder’s employment; direct and derivative claims for breach of fiduciary duty; breach of contract; and a challenge to the validity and fairness of a reverse stock split that cashed out at fair value the minority stockholder’s shares while litigation was pending concurrently in New York and Delaware courts. [Disclosure: The defendants are clients of my firm which served as co-counsel in the New York litigation and acted as lead counsel in connection with the reverse stock split.]

The case spawned a plethora of pretrial motions, lengthy trials in New York Supreme Court and Delaware Chancery Court, and appeals in both jurisdictions. Ultimately, the courts rejected the plaintiff’s claims for unlawful termination of her employment and contract breach, rejected the bulk of her claims against the majority shareholder for breach of fiduciary duty, upheld the validity of the reverse stock split, and upheld the company’s fair value appraisal with modest adjustments. Continue Reading Business Divorce Case Reaches End of Long and Winding Road

The title of this post should come as no surprise to those who follow Delaware corporate law. Unlike New York and the vast majority of other states, Delaware has no statute authorizing an oppressed minority shareholder to petition for judicial dissolution or to compel a buy-out. In its 1993 ruling in Nixon v Blackwell, the Delaware Supreme Court broadly rejected the notion that “there should be any special, judicially-created rules to ‘protect’ minority stockholders of closely-held Delaware corporations” (626 A.2d 1366, 1379). As the court explained, any right to be bought out is a matter of contract, not common law:

The tools of good corporate practice are designed to give a purchasing minority stockholder the opportunity to bargain for protection before parting with consideration. It would do violence to normal corporate practice and our corporation law to fashion an ad hoc ruling which would result in a court-imposed stockholder buy-out for which the parties had not contracted.

Trapped-in minority shareholders in Delaware close corporations who fail to perfect contractual buy-out rights in their shareholder agreements have been forced to pursue alternative theories of relief — and none too successfully. The Delaware Supreme Court, in a decision issued last week in Blaustein v Lord Baltimore Capital Corp., No. 272 [Del. Sup. Ct. Jan. 21, 2014], threw cold water on two alternative theories used by a frustrated minority shareholder whose shareholder agreement permitted but did not require the company to repurchase shares subject to specified levels of board or shareholder consent. Continue Reading Delaware Supreme Court: No Duty to Buy Out Minority Stockholder

Somewhere out on the grasslands of Big Sky Country, the controlling member of a cattle ranch organized as a Montana LLC is sighing "oy vey" instead of singing "yippie-yi-yo-ki-yay" after a recent decision by the Montana Supreme Court holding that the operating agreement’s arbitration clause does not require arbitration of another member’s petition for judicial dissolution of the LLC.  Gordon v. Kuzara, 2010 MT 275 (Dec. 21, 2010).

The case involves an application to dissolve Half Breed, LLC by one of the managing members (Gordon) based on allegations that the controlling member (Kuzara) engaged in a variety of misconduct including diversion of assets and improper accounting and tax reporting.  Kuzara responded with a motion to compel arbitration based on the following arbitration clause in the operating agreement:

Before an action may be brought by any member of the company challenging this agreement, any activity conducted pursuant to this agreement, or any interpretation of the terms of this agreement … one meeting of company members shall thereafter be held for the purpose of resolving a challenge. . . . [I]f a challenge cannot be resolved in such a meeting by a vote of a majority of actual member ownership interests, then the issue shall be submitted to a group of three arbitrators [for binding arbitration].

Continue Reading A Lesson in Arbitration Clause Drafting from Big Sky Country