In Farro v. Schochet, the Second Department recently held that §1002 of the NY LLC Law restricted a dissenting member’s remedy to an appraisal for the fair value of his interest in the business after a freeze-out merger.[1]  Thus, the Court reduced the legal remedies for a minority LLC member that lacked protections in the operating agreement against the merger.

Background on Freeze-out Mergers and Appraisal Remedy

A freeze-out merger typically involves controlling member(s) forcing minority member(s) out of a business by (1) creating a new business where the minority member(s) do not have a stake and then (2) using their controlling stake in the original business to merge it into the new business to freeze-out the minority member(s). 

Many jurisdictions have statutory provisions that protect minority members in freeze-out mergers by giving them the right to receive the fair value of their interest in the original business.  This right is typically enforceable through an appraisal remedy. For example, § 1002(f) and (g) of the NY LLC Law provide the following:

(f) Upon the effectiveness of the merger or consolidation, the dissenting member . . . of any domestic limited liability company shall not become or continue to be a member of or hold an interest in the surviving or resulting limited liability company or other business entity but shall be entitled to receive in cash from the surviving or resulting domestic limited liability company or other business entity the fair value of his or her membership interest in the domestic limited liability company as of the close of business of the day prior to the effective date of the merger or consolidation in accordance with section five hundred nine of this chapter but without taking account of the effect of the merger or consolidation.

(g) A member of a domestic limited liability company who has a right under this chapter to demand payment for his or her membership interest shall not have any right at law or in equity under this chapter to attack the validity of the merger or consolidation or to have the merger or consolidation set aside or rescinded, except in an action or contest with respect to compliance with the provisions of the operating agreement or subdivision (c) of this section.[2]

The Dispute in Farro

Farro involved a series of disputes surrounding LMEG Wireless, LLC, a business created “for the purpose of manufacturing, distributing, and selling aftermarket accessories for cellular telephones.”[3]  Menachem Farro, the plaintiff in this matter, and Levi Wilhelm, one of the defendants, were the initial equal members; Zalman Schochet, another defendant, received a one-third interest from Farro and Wilhelm in 2011.

In 2015, the three members of LMEG attempted to sell the business and associated entities.  As noted in the appellate opinion, “[a]ccording to Schochet and Wilhelm, Farro either undermined the ongoing negotiations or actively opposed the proposed sale, and ultimately, no sale occurred.”[4]

Trial Court Proceedings

In October of 2016, Farro brought this matter in the Kings County Commercial Division—individually and derivatively—against LMEG, Wilhelm, and Schochet for, inter alia, breach of contract and fiduciary duty as well for an accounting;[5]  Farro later amended his complaint to add, inter alia, a claim that Schochet fraudulently acquired his interest in LMEG.[6] Farro also filed an order to show cause to preliminarily enjoin the defendants from holding any corporate meetings “for the purpose of obtaining approval to sell substantially all of their assets and/or transferring substantially all of their assets to any person or entity”[7]—or essentially to effectuate a freeze-out merger.

On November 21, 2016, Schochet and Wilhelm notified Farro that, on November 16, 2016, they approved a merger of LMEG Wireless, LLC with LMEG Acquisition, LLC—under LLC Law §§ 447 and 1002—without any involvement from Farro, and they offered compensation for his interests under those statutes.

In December 2016, Schochet and Wilhelm moved to dismiss Farro’s complaint, and Farro cross-moved for leave for a second amended complaint.  Farro sought to include, among many things, a new claim that the defendant’s failed to comply with the notice and meeting requirements under LLC Law § 1002(c) when they approved the merger and informed him after the fact.[8]

In May of 2017, the trial court denied the defendants’ motion to dismiss, granted Farro’s motion for leave to amend, and denied Farro’s attempt to enjoin the merger as moot.[9]

After the May 2017 decision, Farro gave written notice of his dissent to the November 2016 merger and also stated that he was exercising his rights to receive an appraisal for the fair value of his interest in LMEG.  The defendants then moved for re-argument on the prior order, arguing, inter alia, that LLC Law § 1002(f) and (g) limited Farro’s remedies to an appraisal proceeding and that notice of the merger was not required under LLC Law § 447(a); Farro also moved for re-argument for injunctive relief.[10]

The trial court issued a decision in August of 2017, rejecting the defendants’ sole remedy argument by holding that Farro’s claims fell into an exception that exists “when the merger is unlawful or fraudulent as to that shareholder” and referencing BCL § 623(k)—the codification of this principle in the state’s corporation law—for support.[11]  However, the trial court accepted the defendants’ argument concerning merger procedure, stating “whenever the Limited Liability Company Law requires a member vote, [LLC Law] section 407(a) permits written consents in lieu of a meeting so long as the requisite majority of members execute written consents.”[12]  The trial court also dismissed one of Farro’s breach of contract claims on the basis that he failed to demonstrate a breach.[13]  However, the trial court also granted Farro’s request for injunctive relief, insofar as it dealt with staying the appraisal proceeding “until the parties’ interest in the Businesses is determined.”[14]  Finally, the court noted that the other portions of the previous order stood, resulting in Farro retaining most of his claims. Both sides appealed this decision.

The Second Department’s Decision

On appeal, the Second Department ruled overwhelmingly in favor of the defendants, largely by reversing all of the trial court’s rulings that upheld Farro’s claims.  The Second Department eliminated Farro’s derivative claims on behalf of LMEG—as well as his personal claims for breach of fiduciary duty and accounting—on the basis that “[LLC] Law § 1002(f) provides that, subsequent to a merger, a dissenting member possesses no interest in the surviving or resulting business entity” and is only entitled to cash for his or her fair value in the business.[15]  The panel also held that the trial court should have dismissed Farro’s fraud claim on the basis that LLC Law § 1002(g) “makes clear that an appraisal proceeding is the member's ‘sole remedy,’ and no exception exists for alleged fraud or illegality in the procurement of the merger.”[16]  For support, the Second Department cited to a Court of Appeals opinion interpreting a nearly identical provision in NY Partnership Law as restricting a dissenting limited partner to a sole appraisal remedy and eliminating the fraud or illegality exception.[17]  Given that the appraisal proceeding was Farro’s only remedy, the Second Department also found that the trial court erred in granting Farro a stay on the appraisal proceedings.

The Second Department also affirmed the trial court’s dismissal of one of Farro’s breach of contract claims on inadequate pleading.[18]  The panel also agreed with the trial court’s reasoning in dismissing Farro’s claim that the merger failed to comply with LLC Law § 1002(c) and affirmed the trial court’s determination that Farro’s motion to enjoin the merger was moot.

In sum, the Second Department ruled that the default rules set by New York LLC law allowed the controlling members to execute the freeze-out merger at issue and that the holdout member’s remedy was limited to an appraisal proceeding.  That being said, LLC Law § 1002(g) provides for a carveout for actions “with respect to compliance with the provisions of the operating agreement,” which could allow the minority member(s) to obtain relief if the LLC agreement contains terms, e.g., supermajority or unanimous consent for a merger, that were not followed.