WIll the Pandemic Be a Boon for Future LLC Dissolution Claimants?

Farrell Fritz, P.C.
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The ongoing coronavirus / COVID-19 pandemic has quite literally impacted everyone and everything in New York, including the courts, which were forced to temporarily cease non-essential functions. The result was a short-lived interruption in new business divorce decisions. But we are happy to see decisions of interest to this blog’s readers issuing once again, including a brand new opinion from Manhattan Commercial Division Justice Jennifer G. Schecter involving an attempted dissolution of a business in one of the most heavily impacted sectors of the economy: the health club space.

Justice Schechter’s opinion in Warner v Heath, Decision and Order, Index No. 654714/2018 [Sup Ct NY County May 1, 2020], has plenty of interest to business divorce aficionados:

  • thoughtful legal analysis on (i) the law of LLC dissolution, (ii) the direct versus derivative nature of LLC-member fiduciary duties where a potential sale of the business is involved, and (iii) the availability of punitive damages in business divorce cases
  • highly-quotable passages that courts and litigants may find helpful
  • some tantalizing remarks suggesting that the pandemic’s devastating economic impact on businesses may have implications for future LLC dissolution claims

There’s a lot to unpack from Warner. Let’s get started.

The Facts

Warner, a fitness professional and running coach, had a vision of owning and operating a chain of fitness studios devoted exclusively to running. Warner brought in four original investors. They formed Mile High Run Club, LLC.  The LLC had a detailed operating agreement. The generic “purpose clause” of the operating agreement stated that the LLC was formed “to engage in any activity for which limited liability companies may be organized.”

Each of the five founders was a member of the LLC’s “Board of Managers.” Managers could only be removed for “Cause,” a term defined in the operating agreement.

The company had a rocky financial start. According to Warner, her co-founders failed in their primary responsibility of procuring new investors. In 2018, Warner sued her co-founders. Shortly afterwards, her co-Managers adopted a written consent removing her from the Board. The members told Warner they would decide sometime later whether or not her “removal shall be deemed for Cause.”

In 2019, Warner filed a second amended complaint alleging a mix of 12 tort, contractual, and statutory causes of action. Warner’s co-founders filed a pre-answer motion to dismiss. You can read here the opening, opposition, and reply briefs. In her decision, Justice Schecter granted in part and denied in part the defendants’ motion to dismiss. Warner has many interesting rulings, but we will focus here on three – the Court’s rulings on dissolution under Section 702 of the Limited Liability Company Law, breach of fiduciary duty, and punitive damages.

The LLC Dissolution Claim

The legal test for judicial LLC dissolution in New York, adopted in Matter of 1545 Ocean Avenue, involves a two-fold consideration of the LLC’s ability to achieve its “stated purpose,” and whether the LLC is “failing financially.” As Justice Schecter noted, “dissolution is not permitted pursuant to the statute unless (1) the management of the entity is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved, or (2) continuing the entity is financially unfeasible” (quotations omitted).

Warner stands for a proposition about which we have written many times: it can be awfully tough for minority members to establish grounds for judicial dissolution of a New York LLC. As Justice Schecter noted, “judicial dissolution–an ‘extreme’ remedy–must be granted sparingly.” Quoting Ocean Avenue, the Court noted that courts “may not dissolve” an LLC “merely because the LLC has not experienced a smooth glide to profitability or because events have not turned out exactly as the LLC’s owners originally envisioned,” and “[e]ven in the case of deadlock, dissolution is prohibited if the operating agreement provides a mechanism for resolving that deadlock.”

Warner’s primary argument in support of dissolution was her allegation that her co-Managers wrongfully removed her from the Board. The Court swiftly rejected this argument, ruling that even if Warner were judicially restored to the Board, “she would simply be outnumbered” and outvoted by her co-Managers, ergo, the LLC was able to function without her as Manager.

Moreover, ruled the Court:

To the extent plaintiff had an urgent desire to resume influencing the Company’s direction, she could have sought a preliminary injunction on her wrongful-removal claim. That she has not done so in the more than a year since her removal not only speaks volumes about the practical effect of her removal, but also shows that the Company is capable of fulfilling its stated purpose without her. After all, dissolution is a remedy of last resort. Wrongful removal should result in restoration of her position to the board, not dissolution of the LLC.”

Takeaway? Under Warner, if the petitioner’s membership or management rights have been interfered with or diminished, but there is an adequate alternative to dissolution, the court will be disinclined to grant dissolution, especially where the petitioner could have – but chose not – to pursue that remedy.

Warner’s secondary argument for dissolution was that the company was, at the time of the second amended complaint, “about to financially implode.” Warner “was wrong,” Justice Schecter ruled, and the LLC “continues to own and operate indoor treadmill studios and has opened a third studio during the pendency of this litigation.” In a remarkable passage, the Court then ruled:

Many newer companies will have a debt load far in excess of its assets. Indeed, it is not uncommon for businesses to survive long periods of unprofitability with the long-term goal of gaining significant market share, developing valuable technology or potential synergies with other companies to make it an attractive acquisition target. Selling the Company has, in fact, been a major focus for the last few years. It is not for the court to force closure of newer businesses simply because its principals don’t agree particularly, where, as here, there is an operating agreement that governs. So long as the Company appears to be able to run its business and there is no indication that rent, invoices, and salaries are systematically unpaid, the court will not shut it down.

Takeaway? Under Warner, the “failing financially” prong of the Ocean Avenue test for dissolution may require a prolonged period of “systematic” inability of the company to satisfy its liabilities, and even where such a pattern is shown, the court may be less inclined to dissolve the company where it has voluntarily assumed debt it cannot possibly pay in hopes of making it an “attractive acquisition target.”

The Court did not entirely close the door on Warner’s LLC dissolution claim, however, ruling, “Dissolution may well be required if the Company’s financial situation significantly worsens in the future.” Obviously referring to the coronavirus pandemic, the Court wrote in a footnote: “It is unclear whether current events have rendered continuation of Mile High unfeasible but that is outside the scope” of the current pleading. One can’t help but think that the coronavirus outbreak and its devastating financial impact on health clubs and so many other shuttered businesses can only improve the odds of dissolution under the “failing financially” prong of Ocean Avenue. Perhaps Warner will seek leave to replead based upon these new circumstances. Indeed, the Court granted dismissal of Warner’s dissolution claim “without prejudice” and with permission to seek leave to re-plead “by formal motion” at some later date.

The Fiduciary Duty Claim

Warner pled all of her causes of action directly, not derivatively on behalf of the LLC, a fact which served as a springboard for some very interesting analysis from the Court about the difference between direct and derivative causes of action where a potential sale of the business is involved.

Warner alleged that her co-member, Heath, “presented Mile High’s board and management team an elaborate supposed offer by an alleged investor,” which turned out to be “fake” and was designed to “dissuade the other Managers from accepting a real offer” from a legitimate purchaser. Warner alleged that Heath disfavored the real offer and was inherently self-conflicted because if the Managers accepted the “real offer,” Heath would have lost a “finder’s fee” for raising investors for the LLC.

So the question: where an LLC member misleads a co-member in connection with a potential sale of the business to a third party, is that a direct or derivative cause of action? Superficially, it seems like the harm or damage inures to the LLC, not its individual members, so the claim should be derivative. But the Court held otherwise:

[W]hen management has an opportunity to sell a company in a transaction that would involve divestiture of control, the managers have direct fiduciary duties to the shareholders in connection with the potential sale. . . Fraudulently inducing the board to reject a sale that a fully informed and unconflicted board would conclude is in the best interests of all members is a direct claim because the harm affects the members and not the Company.

For support, the Court in a footnote relied upon Revlon, Inc. v MacAndrews & Fbes Holdings, Inc. (506 A2d 173 [Del 1986]), in which the Delaware Supreme Court ruled that when the sale of a company is involved, the “duty of the board . . . change[s] from the preservation of . . . corporate entity to the maximization of the company’s value at a sale for the stockholders’ benefit.” As Justice Schecter noted, however, “New York has not formally adopted” the rule of law in Revlon.

Takeaway? Under Warner, where a sale of the business is involved, co-members / managers owe one another fiduciary duties to maximize the value of a sale, breach of which can result in a direct, rather than derivative, cause of action. “The claim,” according to the Warner Court, “is necessarily direct because an entity itself is indifferent about whether it is sold; it is the shareholders that stand to lose if managers fail to get the best possible price or forgo a sale to entrench themselves.”

Punitive Damages

The final aspect of Warner we have room to write about is the Court’s holding about punitive damages. Under New York law, punitive damages are ordinarily designed to punish “egregious” conduct directed at the “public at large” (Steinhardt Group Inc. v Citicorp, 272 AD2d 255 [1st Dept 2000]). Not in cases alleging breach of fiduciary duty, held the Court in Warner. “Punitive damages are recoverable on breach of fiduciary duty claims,” the Court held, “irrespective of the otherwise applicable requirements of moral turpitude and harm aimed at the public.” Applying this principle, the Court ruled, “Because the fiduciary duty claim concerning the prospective sale of the Company survives, it is premature to dismiss the possibility that punitive damages are recoverable.”

Takeaway? Pleading breach of fiduciary duty in business divorce cases opens up the possibility of punitive damages, though we have to admit, an award of punitive damages in such cases is exceedingly rare.

We’re thrilled to see business divorce decisions issuing once again in New York, especially of such quality as Warner. A tip of the hat to Justice Schecter for working through the pandemic. We’ll wait and see whether the pandemic results in a deluge of new business divorce filings when courts re-open to new cases, particularly for LLC dissolution on grounds of the business “failing financially.”

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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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