Winter Case Notes: LLC Deadlock and Other Recent Decisions of Interest

by Farrell Fritz, P.C.

This winter forever will be remembered in the Northeast as the winter of the “bomb cyclone,” which gets credit for the 6º temperature and bone-chilling winds howling outside as I write this. So in its honor, I’m accelerating my annual Winter Case Notes synopses of recent business divorce cases, which normally don’t appear until later in the season.

This year’s selections include a variety of interesting issues, including LLC dissolution based on deadlock; the survival of an LLC membership interest after bankruptcy; application of the entire-fairness test in a challenge to a cash-out merger; an interim request for reinstatement by an expelled LLC member; and a successful appeal from a fee award in a shareholder derivative action.

Deadlock Between LLC’s Co-Managers Requires Hearing in Dissolution Proceeding

Advanced 23, LLC v Chamber House Partners, LLC, 2017 NY Slip Op 32662(U) [Sup Ct NY County Dec. 15, 2017].  Deadlock is not an independent basis for judicial dissolution of New York LLC’s under the governing standard adopted in the 1545 Ocean Avenue case but, as Manhattan Commercial Division Justice Saliann Scarpulla explains in her decision, when two co-equal managers are unable to cooperate, the court “must consider the managers’ disagreement in light of the operating agreement and the continued ability of [the LLC] to function in that context.” In Advanced 23, the co-managers exchanged accusations of bad acts and omissions, e.g., one of them transferring LLC funds to an unauthorized bank account, raising material issues of fact as to the effectiveness of the LLC’s management and therefore requiring an evidentiary hearing, which is just what Justice Scarpulla ordered. Of further note, in a companion decision denying the respondent’s motion to dismiss the petition (read here), Justice Scarpulla rejected without discussion the respondent’s argument that judicial dissolution under LLC Law § 702 was unavailable based on a provision in the operating agreement stating that the LLC “will be dissolved only upon the unanimous determination of the Members to dissolve.” In that regard, the decision aligns with Justice Stephen Bucaria’s holding in Matter of Youngwall, that even an express waiver of the right to seek judicial dissolution of an LLC is void as against public policy.

Prior Bankruptcy Narrows Plaintiff’s Standing to Enforce Rights as Member of Several LLCs

Garcia v Garcia, 2016 NY Slip Op 32780(U) [Sup Ct Kings County July 13, 2016].  This 5-page decision by Brooklyn Commercial Division Justice Lawrence Knipel dealt with the plaintiff’s motion seeking a declaration that he did not lose his membership interests in three realty-holding LLCs after going through a personal bankruptcy that resulted in a confirmed chapter 11 plan. As to two of the three LLCs, Justice Knipel held that the plaintiff’s membership interests never passed to his bankruptcy estate under 11 USC § 541 because the other members validly expelled him from the LLCs before he filed for bankruptcy. As to the remaining LLC, from which the plaintiff had not been expelled prior to filing for bankruptcy, Justice Knipel held unenforceable under § 541 a provision in the operating agreement purporting to dissociate a member automatically upon filing for bankruptcy. Justice Knipel accordingly granted the requested declaration as to that one LLC and also granted the plaintiff’s request for access to the LLC’s books and records.

Defendant on Both Sides of Cash-Out Merger Fails to Win Dismissal of Minority Shareholder Suit Alleging Inadequate Consideration 

RAL Capital Ltd. v CheckM8, Inc., 2017 NY Slip Op 32000(U) [Sup Ct NY County Sept. 21, 2017].  This is one of those relatively infrequent challenges to a cash-out merger involving New York-based Delaware corporations that gets litigated in a New York court rather than in Delaware Chancery Court. Presumably there was no forum selection clause on the scene mandating that the suit be brought in Delaware. In her decision, Manhattan Commercial Division Justice Eileen Bransten dismissed an array of the shareholder claims, but left standing the central claim for breach of fiduciary duty against the individual defendant who was CEO and majority shareholder of the non-surviving company and sole shareholder of the surviving company following completion of the merger. Justice Bransten found that the defendant failed to carry his burden in opposing dismissal to show that the transaction satisfied both prongs of the “entire fairness” test under Delaware law, i.e., fair dealing and fair price. Among the more salient factors cited in Justice Bransten’s decision, the defendant did not obtain an independent appraisal; failed to disclose his position as CEO, director and sole shareholder of the merged-into company; and failed to obtain approval by an informed majority of minority shareholders.

Court Declines Interim Mandatory Injunction Sought by Expelled LLC Member

Ho v Yen, 2017 NY Slip Op 32732(U) [Sup Ct Queens County Nov. 13, 2017].  Requests for preliminary injunctions at the outset of business divorce litigation are quite common. Most of the time, the interim injunction is designed to maintain the status quo pending the ultimate determination of the parties’ claims. Sometimes, though, the party asks for mandatory instead of prohibitory injunctive relief which, as Queens County Commercial Division Justice Marguerite A. Grays explains in this case, is an “extraordinary and drastic remedy” that requires “unusual circumstances where such relief is essential to maintain the status quo pending trial of the action.” The plaintiff in this case, who sued to reverse his expulsion as a member of a realty-holding LLC, and sought an injunction requiring his reinstatement during the lawsuit’s pendency, failed to satisfy the high standard for such relief. Justice Grays noted that the plaintiff allegedly had been locked out of the company two years earlier, and therefore could not show a violation of a right presently occurring; that he did not show by “clear and convincing evidence” that he held a one-third membership interest in the LLC or had been expelled improperly; and that he improperly sought on an interim basis the ultimate relief sought by his lawsuit.

Appellate Court Reverses Fee Award in Shareholder Derivative Action for Lack of Standing

Sakow v Waldman, 155 AD3d 1078, 2017 NY Slip Op 08403 [2d Dept Nov. 29, 2017].  In a shareholder derivative action, a 25% shareholder obtained for the corporation’s benefit a post-trial judgment for over $5 million against the 75% shareholder which was affirmed on appeal in early 2015. He subsequently obtained a $300,000 award for attorney’s fees as the prevailing plaintiff in a derivative lawsuit under § 626 (e) of the Business Corporation Law. The defendant opposed the fee award in its entirety, claiming that he recently discovered that many years prior the plaintiff transferred his shares to a trust for the benefit of his son and therefore lacked standing to seek a fee award. The plaintiff argued, and the lower court agreed, that under a “nominee agreement” with the trust produced by the plaintiff he maintained an interest in the stock and therefore remained entitled to seek a fee award. The defendant appealed to the Second Department which vacated the fee award, holding that the plaintiff was not a shareholder and did not have a beneficial interest in the shares at the time of the challenged transaction and at the time the action was commenced, and therefore did not have standing to seek a fee award.

[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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