In the annals of business divorce litigation and assorted other disputes between co-owners of closely held business entities, the cause of action for breach of the implied covenant of good faith and fair dealing likely wins the prize for the claim least understood by practitioners and most frequently dismissed by judges.

As I’ve written before, and as Professor Dan Kleinberger noted in his guest post on this blog, at least part of the confusion comes from its name. Start with the term “implied covenant.” To the average reader, it connotes a duty imposed by law without regard to the parties’ intentions and without mutual consent, like a fiduciary duty (the implied covenant often is referred to as the “implied duty”). Next comes “good faith,” connoting something done sincerely and honestly, without malice, disloyalty, or a desire to deceive or defraud. Finally comes “fair dealing.” Fair is fair is the opposite of unfair, right? Put them all together, and you’ve got what sounds like an all-purpose “lite” version of some quasi-fiduciary duty, enabling a court of equity to apply free-floating standards of honesty and fairness to adjust relations between business partners.

By and large, court decisions out of the Delaware Chancery Court have done a far better job than their New York counterparts in explaining the implied covenant’s strictly contractual roots and its parsimonious reach. A particularly good example is Vice Chancellor Sam Glasscock III’s recent Memorandum Opinion in Miller v HCP & Co., C.A. No. 2017-0291-SG [Del Ch Feb. 1, 2018], in which he dismissed a suit brought by a minority member of an LLC alleging that the controller breached the implied covenant by selling the company for $43 million to a third party via private sale rather than conducting an open-market sale or auction to ensure maximum value for all members under the operating agreement’s waterfall. Continue Reading Will Someone Please Re-Name the Implied Covenant of Good Faith and Fair Dealing?

The test for judicial dissolution of LLCs under LLC Law § 702, as laid down in 1545 Ocean Avenue, initially asks whether the managers are unable or unwilling to reasonably permit or promote realization of the LLC’s “stated purpose” as found in its operating agreement.

I would venture to say that the overwhelming majority of operating agreements, in their purpose clauses, use the phrase “any lawful business” which, not coincidentally, mirrors the enabling language found in LLC Law § 201, authorizing LLCs to be formed for “any lawful business purpose.” Boiler-plate or not, using “any lawful business” in the purpose clause can be a prudent drafting technique to avoid future conflict or need to amend the operating agreement should the LLC’s business model change in response to future events. Of course, there are some circumstances, often involving single asset real estate holding companies, when stating a specific purpose is the more prudent technique.

Which is why last summer’s decision by the Appellate Division, Second Department in Mace v Tunick was such an eye opener. In Mace, the court held that the “any lawful business” purpose clause in the operating agreement at issue did not state any purpose, and on the basis that the lower court had engaged in impermissible fact-finding on a pre-answer dismissal motion, reversed the lower court’s summary dismissal of the minority member’s dissolution suit and remanded the case for further proceedings.

If “any lawful business” states no purpose, I queried in my prior post on the case, does “the primary focus of the judicial dissolution standard under 1545 Ocean Avenue — whether the LLC’s managers are willing or able to achieve its stated purpose under the operating agreement — merely becomes a waystation on the road to more protracted litigation proceedings requiring discovery and evidentiary hearings”?

I still don’t have the definitive answer to that question, but I can tell you what happened in Mace on remand to the lower court, and after the lower court conducted a trial. Continue Reading The Purposeless Purpose Clause Makes a Comeback — Or Does It?

The sudden death of Alexander Calderwood, the brilliant but troubled co-founder of the Ace brand of hotels, resulted in some fierce litigation between Calderwood’s estate and Calderwood’s LLC co-member over the nature of his estate’s membership interest in the company after his death. The litigation came to a head earlier this month, when Justice Barbara R. Kapnick issued a scholarly decision for a unanimous panel of the Appellate Division, First Department in Estate of Calderwood v ACE Group Int’l, LLC, 2017 NY Slip Op 08750 [1st Dept Dec. 14, 2017].

Boiled down, the question on appeal was whether, under Delaware law, Calderwood’s estate was a bona fide member of the LLC with all of a member’s associated rights and privileges, or instead, a mere assignee of Calderwood’s membership interest. As written about in a post last Spring (read here), New York County Commercial Division Justice Shirley Werner Kornreich issued a decision dismissing most of the Estate’s amended complaint, holding that the Estate lacked membership status in the LLC upon Calderwood’s death. Let’s see how the appeals court considered the issue. Continue Reading Delaware Contractarian Principles Prevail in Appeal Over Deceased Ace Hotel Founder’s LLC Interest

When the tsunami of LLC enabling statutes swept the U.S. in the late ’80s and early ’90s, including New York in 1994, many included a default rule authorizing as-of-right member withdrawal and payment for the “fair value” of the membership interest. The default rule was one of many designed to avoid C corporation-style “double taxation” of LLC earnings. After 1997, when the IRS adopted check-the-box regulations cementing pass-through partnership tax treatment for LLCs, New York and other states flipped the default rule, i.e., members are no longer permitted to withdraw unless authorized by the operating agreement.

When New York amended its withdrawal provision, LLC Law § 606, it included a new subsection “b” grandfathering LLCs formed before the amendment’s 1999 effective date, meaning that withdrawal under the “old” § 606 and fair-value buyout under LLC Law § 509’s default rule remain available for members of pre-1999 LLCs — so long as not otherwise provided in the operating agreement. The Chiu case, which I wrote about here, is an example of one such case resulting in a fair-value buyout of a withdrawn member.

After the amendments, some pre-1999 New York LLCs adopted new operating agreements or amended their existing ones to prohibit withdrawal. Some, as in Chiu, did not.

This is a story about one LLC that did not, but with a very different outcome than Chiu. The story’s punch line, which makes it a fascinating one, is that even though the minority member, seeking to force a fair-value buyout, was found to have properly invoked his uncontested right to withdraw under the old § 606, in the end the lower and appellate courts held that his withdrawal did not trigger a statutory buyout under § 509 because the LLC’s operating agreement included mandatory rights of first refusal — with which the minority member never complied — that displaced the buyout statute’s default rule.

The case, Matter of Jacobs v Cartalemi, was decided last week by the Appellate Division, Second Department, along with two decisions in companion appeals in related cases in which the court held that upon withdrawal the minority member also lost his standing to pursue derivative claims against the controlling member. I’ll explain all below, but before doing so I must disclose that, along with co-counsel, my firm and I represent the controlling member of the LLC in each of the cases. Continue Reading Operating Agreement Defeats Statutory Buyout Rights Upon LLC Member’s Withdrawal

A dissolution petitioner received the judicial equivalent of the old quip “Where’s the beef?” in a Brooklyn appeals court decision last week reversing an order dissolving a limited liability company under Section 702 of the Limited Liability Company Law. In Matter of FR Holdings, FLP v Homapour, 2017 NY Slip Op 07439 (2d Dept Oct. 25, 2017), the Appellate Division, Second Department, sent the case back to the drawing board, despite the LLC having been in receivership for more than two years, because the petitioner “offered no competent evidentiary proof” in support of his petition for dissolution.

A Common Fact Pattern

FR Holdings involved a common fact pattern. 3 Covert LLC (“Covert”) was formed to own and operate a mixed-use apartment and commercial building in Brooklyn.  Under the operating agreement, the purpose of the member-managed LLC was “to purchase and sell residential and commercial real estate and to engage in all transactions reasonably necessary or incidental to the foregoing.” Section 6.01 (a) of the operating agreement permitted most actions by “the vote or consents of holders of a majority of the Membership Interests.” As alleged in the petition, the LLC had five members, four of whom each held 12.5% interests. The fifth member, FR Holdings, owned a 50% interest. Continue Reading “Where’s the Beef?” Says Appeals Court, Reversing LLC Dissolution

I’ve seen LLC operating agreements ranging from one page to over 100. Usually there’s a direct relationship between the length of the agreement and the complexity of the LLC’s capital and management structure.

But if there’s one thing I’ve learned about LLC agreements, it’s that no matter how comprehensive and tome-like their design, there’s no guarantee that a future, unanticipated dispute won’t expose the inevitable cracks in the design prompting the need for court intervention. Indeed, depending on the drafter’s skill, one can argue the more complex the LLC agreement, the greater the risk of a court contest over its interpretation.

Take the recent case of Tungsten Partners LLC v Ace Group International LLC, 2017 NY Slip Op 32025(U) [Sup Ct NY County Sept. 20, 2017], in which Manhattan Commercial Division Justice Shirley Werner Kornreich was called upon to decide whether the plaintiff holder of a 4% non-voting profits interest, identified as a “Management Member” in a 65-page operating agreement (plus another 170 pages of schedules and exhibits), was a member of the subject Delaware LLC for purposes of demanding access to books and records under § 18-305 of the Delaware LLC Act. Continue Reading A Member By Any Other Name . . . May Have Access to LLC Books and Records

New York’s LLC judicial dissolution statute, Section 702 of the Limited Liability Company Law, provides far more limited grounds to dissolve a business than the Business Corporation Law – a harsh reality for allegedly mistreated minority members highlighted by a recent decision by Manhattan Supreme Court Justice David B. Cohen.

In Matter of Felzen v PEI Mussel Kitchen, LLC, 2017 NY Slip Op 31831(U) [Sup Ct, NY County Sept. 1, 2017], Felzen sued to dissolve the company that operates a pair of Manhattan seafood restaurants named Flex Mussels, based upon allegations of breach of fiduciary duty, looting and oppression – frequent grounds for dissolution under Section 1104-a of the Business Corporation Law.  In Matter of Zafar, an earlier decision written about on this blog, comparable allegations – i.e., “persistent self-dealing and dishonest conduct” – sufficed to dissolve an LLC.  Let’s see how things turned out here. Continue Reading LLC’s Purpose Being Achieved? Business Doing Fine? Good Luck Getting Judicial Dissolution

WARNING: Contractarians may find the following post disturbing. Reader discretion is advised.

Now that I’ve got your attention, consider this:

  • Under the standard for judicial dissolution of a New York LLC prescribed in the landmark 1545 Ocean Avenue case, the primary, contract-based inquiry is whether the LLC’s managers are unable or unwilling to permit or promote the stated purpose of the entity, as found in the LLC’s operating agreement or articles of formation, to be realized or achieved.
  • The typical, broad purpose clause found in untold thousands of standardized and customized LLC agreements provides that the LLC’s purpose is “any lawful business,” mirroring Section 201 of the LLC Law (“A limited liability company may be formed under this chapter for any lawful business purpose or purposes”).
  • When a fully integrated operating agreement states that the LLC’s purpose is “any lawful business,” may a minority member of an LLC nonetheless seek judicial dissolution based on extrinsic (parol) evidence that those in control of the LLC are operating it for a lawful business purpose that departs from the LLC’s alleged original lawful business purpose?

Until last week’s decision by the Brooklyn-based Appellate Division, Second Department — the same court that gave us 1545 Ocean Avenue — in Mace v Tunick, 2017 NY Slip Op 06170 [2d Dept Aug. 16, 2017], I would have answered that question “no” with support from a number of case precedents in New York and other jurisdictions including that hotbed of contractarian jurisprudence known as Delaware. After Mace, it appears that the “any lawful business” purpose clause may be as good as no purpose clause. Continue Reading Does Your LLC Agreement Have a Purposeless Purpose Clause?

In 1981, three partners formed a general partnership to own and operate a rental property. Their partnership agreement fixed a 30-year term, to 2011. In 2003, the partners formed a new LLC maintaining the same ownership percentages as the partnership, to which the partnership transferred the property for purposes of refinancing the existing mortgage loan.

In 2016, after failing to secure a buy-out agreement, the holder of a 45% interest sued to dissolve the LLC under New York LLC Law § 701 (a) based on the 2011 expiration date in the partnership agreement.

But wait, you say, didn’t the LLC supersede the partnership and, if so, how can the LLC’s duration be governed by the termination date in the partnership agreement? Unless there’s an LLC agreement that provides otherwise, isn’t the LLC’s existence perpetual by default? And how can the owners hold themselves out to the world as an LLC while acting as partners among themselves? After all, it was the mortgage lender that likely required the transition from partnership to LLC as a condition of the loan, among other reasons, precisely to avoid the risk associated with a general partner’s unfettered right to dissolve the partnership at any time for any reason.

An interesting set-up, indeed, for a decision last week by Manhattan Commercial Division Justice Saliann Scarpulla in Golder v 29 West 27th Street Associates, LLC, 2017 NY Slip Op 31527(U) [Sup Ct NY County July 17, 2017], in which she denied a motion to dismiss the dissolution petition upon finding “a material issue of fact exists as to whether a written operating agreement exists as to the LLC’s term of duration.” Continue Reading It’s a Partnership! No, It’s an LLC! No, It’s Both!

NY

DelawareThe common perception among practitioners familiar with the business entity laws of New York and Delaware is that Delaware law generally is friendlier to, and more protective of, majority ownership and management interests.

Two recent cases — one from each state — highlight at least one important area where the common perception does not apply: majority rights under the statutory default rules to adopt or amend an LLC operating agreement without the consent of all the members.

The difference between the two states can have critical consequences for both majority and minority members of the many LLCs that, for better or worse, are formed without a written operating agreement.

The New York case is one I previously wrote about on this blog. Last January, in Shapiro v Ettenson, the Appellate Division, First Department, in a case involving a three-member LLC that was formed without a written operating agreement, affirmed a lower court’s decision construing Section 402 (c) (3) of the New York LLC Law (“except as provided in the operating agreement . . . the vote of a majority in interest of the members entitled to vote thereon shall be required to . . . adopt, amend, restate or revoke the articles of organization or operating agreement”) to permit the two-member majority to adopt a written operating agreement almost two years after the LLC was formed and began operating, without the third member’s consent and notwithstanding certain provisions in the agreement that modified the statutory default rules adversely to the third member. Continue Reading Delaware Ruling Highlights Difference With New York Over Amending LLC Agreements