Two Entities, Two Outcomes: Withdrawal and the Right to an Accounting

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In Jacobs v Cartalemi, now the leading case on the subject of LLC member withdrawal (which our firm had the pleasure of litigating), the Appellate Division – Second Department repeated a well-established principle of law: “The right to an accounting is premised upon the existence of a confidential or fiduciary relationship and a breach of the duty imposed by that relationship respecting property in which the party seeking the accounting has an interest.”

The Cartalemi Case

In Cartalemi, the Court applied this rule of law to reverse the denial and grant dismissal of an accounting claim of a withdrawn LLC member. The Court held, “Here, the plaintiff’s right to an accounting was based on his ability to prove that [his co-member] breached his fiduciary duty to [the LLC], a claim that is entirely derivative and which the plaintiff, having withdrawn as a member from [the LLC], no longer had standing to maintain.” Under Cartalemi, a withdrawn LLC member lacks standing to bring a derivative claim for an accounting post-withdrawal from the LLC.

Is the rule the same for partnerships? If not, why is there a difference? A recent decision from the same appeals court that issued Cartalemi highlights important some distinctions between the accounting rights of withdrawn owners of LLCs and partnerships.

The Zohar Case

Zohar v LaRock, 185 AD3d 987 [2d Dept 2020], was an appeal from a Short Form Order of Nassau County Commercial Division Justice Stephen A. Bucaria. In Zohar, three attorneys formed a law firm limited liability partnership (the “Firm”). The Firm had a written partnership agreement permitting voluntary withdrawal from the partnership upon 60 days’ prior notice. Opting out of the default rule of Partnership Law § 62 (1) (b) and (2), which provides that a partner’s withdrawal automatically dissolves the partnership by operation of law, the partnership agreement stated that the partnership “shall not be dissolved” upon withdrawal.

Further opting out of the default rule of Partnership Law § 69 (1), which provides a method for liquidation of dissolved partnerships at will, the agreement stated that if a partner withdrew, he would be entitled to receive payment for his equity in “an amount equal to the Buy-Out Price.” The partnership agreement defined “Buy-Out Price” as the multiple of the Firm’s “Net Book Value” and the withdrawn partner’s “Partner Sharing Ratio.” If Zohar or LaRock withdrew, he would also be entitled to “50% of the balance in the operating account” as of the date of the partnership agreement.

Days after his co-partners held a meeting and reduced his partnership interest from 25% to 15%, Zohar withdrew from the Firm. The day he left, he withdrew $49,750 from the firm’s bank accounts, $45,000 of which he calculated as his “Buy-Out Price” based upon a 25% partnership interest in the Firm, and $4,750, which he calculated to be the return of his capital contribution to the Firm. The next day, he filed a lawsuit against his co-partners alleging two claims: (i) breach of the partnership agreement for reducing his percentage interest from 25% to 15% and (ii) an accounting.

The Summary Judgment Decision

After six years of litigation, Justice Bucaria ruled (in a decision we previously wrote about here) that Zohar was a 15% (rather than 25%) partner on the date of withdrawal. The Court granted Zohar summary judgment on his claim for an accounting, ruling, “The act of dissolution, upon the withdrawal of a partner, confers upon the withdrawing partner the right to an account of his interest, as against the partnership continuing the business. . . Thus, Zohar is entitled to an accounting of his interest” as of the date of his withdrawal “regardless of the provision of [the partnership agreement] that the partnership would not be dissolved” upon withdrawal. Then the Court “on its own motion” ordered a methodology for the accounting differing in certain respects from the “Buy-Out Price” formula under the partnership agreement.

The Appeal

Both sides appealed. You can read the principal briefs here and here (LaRock, Perez, and the Firm’s argument that Zohar was not entitled to an accounting incorporated their arguments from a prior appeal brief, which you can read here). A big thank you to Larry Goodman for sending me the briefs. In a nutshell, the majority partners argued that, under the partnership agreement, the partnership continued post Zohar’s withdrawal, and that Zohar was entitled solely to the “Buy-Out Price” based upon the formula in the contract, not a full-blown accounting. This argument closely resembled the argument that prevailed in Cartalemi. How did the argument fare in Zohar?

In July 2020, an astonishing 21 months after the appeal was orally argued, the Second Department ruled that Zohar was entitled to an accounting, even though (i) he ceased to be a partner upon his withdrawal, (ii) the partnership continued post-withdrawal, and (iii) the partnership agreement contained a buyout formula in lieu of liquidation. Reciting the exact rule of law the Court relied upon to deny an accounting in Cartalemi, the Court explained, “The right to an accounting is premised upon the existence of a confidential or fiduciary relationship and a breach of the duty imposed by that relationship respecting property in which the party seeking the accounting has an interest.”

Applying this principle, the Court ruled:

Here, we agree with the Supreme Court’s determination awarding the plaintiff summary judgment on the cause of action for an accounting to determine the amount due to him pursuant to the terms of the partnership agreement. ‘Generally, to be entitled to an equitable accounting, a plaintiff must demonstrate that he or she has no adequate remedy at law. However, where . . . there is a fiduciary relationship between the parties, there is an absolute right to an accounting notwithstanding the existence of an adequate remedy at law’ (Webster v Forest Hills Care Ctr., LLC, 164 AD3d 1499, 1501 [2018] . . .). Here, it is undisputed that there was a fiduciary relationship between the plaintiff and the defendants. . . Given the terms of the partnership agreement, although the firm did not dissolve upon the plaintiff’s withdrawal on August 3, 2010, and the plaintiff had a remedy at law, the plaintiff established his prima facie entitlement to an accounting as of the date of his withdrawal (see e.g. Dawson v White & Case, 88 NY2d 666, 670 [1996]). In opposition, the defendants failed to raise a triable issue of fact.

Why Partnership but Not an LLC Accounting

So turning to the question that inspired this article: why did the withdrawn partner in Zohar get an accounting but not the withdrawn member in Cartelemi? I see at least three explanations.

First, there is one-hundred-year tradition dating back to the 1918 enactment of the Partnership Law of courts granting general partners very broad accounting rights. The partner’s right to an accounting is codified in several statutes, including Sections 42, 43, and 44 of the Partnership Law. The Limited Liability Company Law lacks an equivalent statute granting members such broad accounting rights, though it is now well settled that LLC members (at least non-withdrawn ones) may be entitled to an accounting from their co-members under common law principles.

Second, the withdrawn partner in Zohar sued directly for injury to himself as a general partner. The withdrawn member in Cartalemi sued derivatively on behalf of the LLC, a critical distinction. As we have often noted, characterization of claims as direct versus derivative can fundamentally affect the validity of the claim. One could argue that if the withdrawn member in Cartalemi had somehow managed to plead his accounting claim as direct, the outcome might possibly have been different. Having failed to plead injury to himself distinct from the LLC, however, his accounting claim was dismissed based upon the principle that an LLC member’s withdrawal, even if involuntary, defeats standing to sue derivatively (see e.g. Maldonado v DiBre, 140 AD3d 1501 [3d Dept 2016], lv denied 28 NY3d 908 [2016] [“even if, as plaintiffs claim, the loss of the units was not voluntary, they still would not have standing to pursue derivative claims”]).

Third, the “Buy-Out Price” formula in the partnership agreement in Zohar, specifically its reference to the Firm’s “Net Book Value,” inherently required the non-withdrawn partners to account to Zohar to determine the value of his former partnership interest.

Partners’ Contractual Freedom to Prohibit an Accounting

Does a withdrawn general partner have a right to an accounting in all cases? Doubtful. As the Court of Appeals stated in Congel v Malfitano, 31 NY3d 272, 288 [2018], the “partners of either a general or limited partnership, as between themselves, may include in the partnership articles any agreement they wish concerning the sharing of profits and losses, priorities of distribution on winding up of the partnership affairs and other matters.” Under Congel, general partners are certainly permitted to include in their partnership agreement a provision that, upon withdrawal, the withdrawn partnership shall not be entitled to an accounting. The same is true, of course, for LLC operating agreements. But given the long history and explicit statutory provisions in favor of partnership accountings, the language of a partnership agreement must be unmistakably clear, otherwise chances are strong a withdrawn New York general or limited partner may be able to persuade a court to require his co-partners to render an accounting.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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