New York LLC Caselaw’s Greatest Hits | Farrell Fritz, P.C.

I recently had the privilege of speaking to an audience of judges of the New York Supreme Court Commercial Division at Fordham Law School’s Eileen Bransten Institute on Complex Commercial Litigation. Naturally, the topic was business divorce litigation. My co-panelists Chris Mercer (Mercer Capital) and William Savino (Woods Oviatt Gilman LLP) respectively spoke about the marketability discount in fair value appraisal proceedings and caselaw developments concerning closely held business corporations.

My segment offered what I labelled a “semi-critical retrospective” assessment of the state of New York law concerning LLC business divorce. First, I discussed how tax considerations dictated key elements of the original design and subsequent amendment of New York’s LLC Law. I also observed how those developments have hobbled the ability of New York courts to resolve disputes among co-owners of LLCs and especially in dissolution cases, at least compared to the majority of states that have adopted the Revised Uniform LLC Act or otherwise have similarly updated their LLC statutes, unlike New York.

Next, I gave a chronological, verbal travelogue of court decisions I selected as the “greatest hits” of New York case law since the LLC Law’s enactment in 1994. I highlighted those that have shaped business divorce litigation involving LLCs, showcasing both the statute’s limitations and how courts have achieved some workarounds.

I thought it might be useful to share with a wider audience the substance of my presentation. What follows is adapted from the handout material I prepared for the Commercial Division judges.

I. The LLC Law: Background

  • The first LLC statute was enacted by Wyoming in 1977, creating a limited liability, hybrid entity designed as a pass-through tax entity, governed largely by default rules.
  • The LLC movement stalled until 1988 when the IRS issued Revenue Ruling 88-76 recognizing pass-through partnership tax classification for the Wyoming LLC.
  • A nationwide avalanche of LLC legislation followed, with New York enacting its LLC Law in 1994 with minimal legislative history and a last-minute deletion of the bill’s article authorizing derivative actions.
  • Revenue Ruling 88-76 essentially dictated the original dissociation and dissolution provisions of LLC statutes, including New York’s, by requiring default rules that would cause the LLC to fail the test for continuity of life by mimicking dissociation and dissolution provisions for partnerships.
  • New York LLC Law Section 606 (member withdrawal), Section 701 (non-judicial dissolution), and Section 702 (judicial dissolution) were largely modeled on New York’s Revised Limited Partnership Act, featuring partnership-like exit opportunities but a higher bar for judicial dissolution compared to business corporations:
  • Section 606’s original default provision authorized unconditional member withdrawal upon 6-months advance notice coupled with fair-value buyout under Section 509.
  • Section 701’s original default provision mandated dissolution by operation of law upon certain specified events including member dissociation, unless the remaining members voted to continue the business.
  • The “not reasonably practicable” language in Section 702 mirrors Section 121-802 of the RLPA as well as Section 902 of the ABA’s 1992 Prototype LLC Act in which the drafters’ commentary suggested deliberate avoidance of typical grounds found in corporate dissolution statutes on the ground that “disgruntled” LLC members “would be encouraged to make this sort of allegation” in LLC breakups.
  • The pace of new LLC formation gathered nationwide momentum after 1997 when the IRS adopted “check-the-box” regulations. The regulations automatically classified any new unincorporated entity with two or more members as a partnership for tax purposes unless it elects a different status. In the following decades the LLC has become the entity of choice for newly formed companies, although New York has lagged due in large part to its costly publication requirement.
  • With the cancellation of the anti-continuity of life requirement, check-the-box also triggered a nationwide avalanche of amendments to LLC statutes. New York was no exception. In 1999, the legislature jettisoned the partnership model and “flipped” the default rules in Sections 606 and 701. The former now prohibited member withdrawal. The latter now provided for non-dissolution upon specified events including member dissociation unless the members voted to dissolve. [Note: The amendments preserve the statute’s original provisions for LLCs formed prior to the amendments.]
  • The legislatively hindered exit opportunities — some refer to it as the “corporatization” of LLCs — were not accompanied by amendment of Section 702’s stringent provision for judicial dissolution, placing LLC minority members at greater risk of squeeze-out and other oppressive conduct by LLC controllers but without the broader grounds for dissolution available to similarly situated minority shareholders under BCL Section 1104-a and its companion elective buyout under Section 1118.
  • Since 1999 there have been no amendments to the LLC Law’s provisions regulating intra-company member relations.
  • Unlike the detailed procedural and remedial features in BCL Article 11 governing judicial dissolution of close corporations, LLC Law Section 702 is unaccompanied by any provisions specifying the mode of bringing suit as a plenary action vs. special proceeding, or any other procedural requirements or interim remedies available in a lawsuit seeking judicial dissolution of an LLC.
  • For more on the history of the LLC movement and New York’s early experience with the LLC Law in business divorce cases, see P. Mahler, When Limited Liability Companies Seek Judicial Dissolution, Will the Statute Be Up to the Task?, 74 NYS Bar Assoc. Journal, June 2002, Vol. 74, No. 5. Unfortunately, in this writer’s opinion, some of the significant statutory shortcomings noted in the article I wrote over 20 years ago remain with us today. While legislatures in most other states have overhauled their LLC statutes to give greater protection to minority LLC members against majority oppression and greater remedial powers to judges, including 24 states (and another four with pending legislation) that have enacted versions of the Revised Uniform LLC Act. Then there are non-RULLCA states such as Delaware that regularly re-visit and update their business entity laws, while our New York legislators seemingly pay no attention.

II. Caselaw “Greatest Hits”

1999: Judicial Dissolution à la BCL. In what appears to be the earliest appellate decision applying Section 702, decided five years after the statute’s enactment, the Fourth Department in Matter of Roller, 259 A.D.2d 1012, 689 N.Y.S.2d 897 (4th Dept. 1999), affirmed without analysis an order denying a motion to dismiss a dissolution petition. The underlying petition essentially mimicked allegations typically found in a petition for judicial dissolution of a corporation under Sections 1104 and 1104-a of the Business Corporation Law, i.e., exclusion from LLC’s business affairs, internal dissension, irreconcilable conflict such that dissolution would be beneficial to the membership, denial of access to records, and that dissolution would not injure the public. Not until the 1545 Ocean Avenue decision 11 years later (see below) was there a clear, appellate repudiation of importing the BCL standard into LLC dissolution jurisprudence.

2004: The “Statutory Operating Agreement”. In Matter of Spires v Lighthouse Solutions, LLC, 4 Misc.3d 428, 778 N.Y.S.2d 259 (Sup. Ct. Monroe County 2004), an LLC member sought judicial dissolution of an LLC not under Section 702, but under the far more liberal standards in Partnership Law Section 62. The petitioner alleged that because the LLC had no written operating agreement as required by LLC Law Section 417(a), the entity did not attain LLC status and therefore had to be treated as a partnership. Spires was the first case to hold that the members’ failure to adopt an operating agreement did not make it a partnership; that the LLC came into existence upon filing its articles of organization with the Secretary of State; and that in the absence of an operating agreement the LLC is governed by a “statutory operating agreement” consisting of the LLC Law’s mandatory and default provisions including judicial dissolution under Section 702. Spires‘ legacy is at work in the many business divorce cases among members of LLCs that have no written operating agreement.

2006: Oppression Not Grounds for Dissolution. In Widewaters Herkimer Co., LLC v Aiello, 28 A.D.3d 1107, 817 N.Y.S.2d 790 (4th Dept. 2006), without mentioning its decision seven years earlier in Matter of Roller (discussed above), the Fourth Department seemingly turned its back on Roller by rejecting allegations of oppression by the majority members — the statutorily authorized basis for seeking dissolution under BCL Section 1104-a– as ground for judicial dissolution under Section 702. (More recent authority echoing Widewaters includes Doyle v ICON, LLC, 103 A.D.3d 440, 959 N.Y.S.2d 200(1st Dept. 2013), where the First Department wrote, “Plaintiff’s allegations that he has been systematically excluded from the operation and affairs of the company by defendants are insufficient to establish that it is no longer ‘reasonably practicable’ for the company to carry on its business, as required for judicial dissolution under [LLCL] § 702.”. Another is Barone v Sowers, 128 AD3d 484, 10 N.Y.S.3d 22 (1st Dept. 2015).)

2006: Dissolution Under Section 702 “Not As Easy” as Under BCL. Matter of Horning v Horning Construction, LLC, 12 Misc.3d 402, 816 N.Y.S.2d 877 (Sup. Ct. Monroe County 2006), is the first decision I know of following the LLC Law’s enactment 12 years earlier, that undertook a detailed, scholarly analysis of Section 702, its derivation, and out-of-state LLC dissolution precedent. Along with the Widewaters case discussed above, it’s also one of the earliest cases to distance the analysis of grounds for dissolution under Section 702 from that under the Business Corporation Law’s provisions for judicial dissolution of close corporations. The decision noted that dissolution under Section 702 is “not as easy” as dissolution under the BCL, and went on to dismiss the dissolution petition before it which alleged petitioner’s inability to secure a buy-out agreement and animosity between the members.

2006: Closed Auction as Equitable Method of Liquidation. In Lyons v Salamone, 32 AD3d 757, 821 N.Y.S.2d 188 (1st Dept. 2006), the First Department affirmed an order granting a 20% member’s claim for judicial dissolution of a two-member LLC. The case’s significance stems from the court’s remedial order, over the plaintiff’s objection compelling a closed auction sale between the two members allowing either party to bid the fair market value of the other party’s interest in the business. The decision referred to the auction sale as “an equitable method of liquidation” notwithstanding “the absence of a provision in the Limited Liability Company Law expressly authorizing a buyout in a dissolution proceeding,” with the court-appointed receiver “directed to accept the highest legitimate bid.” While I have not seen any reported cases since Lyons ordering an auction sale remedy, it remains important as a precursor to the equitable buyout remedy recognized some years later in the Mizrahi case (see below).

2008: Common-Law Right to Sue Derivatively Recognized. To date, in the almost 30 years since its enactment, Tzolis v Wolff, 10 N.Y.3d 100, 855 N.Y.S.2d 6 (2008), amazingly stands as the only case construing the LLC Law decided by our Court of Appeals. But it was a big one. Recall that the legislature when it passed the LLC Law dropped the article providing for derivative actions. In Tzolis , a divided Court of Appeals recognized a common-law right of members to bring derivative actions on behalf of LLCs. The majority opinion found the legislative history “too ambiguous to permit us to infer that the Legislature intended wholly to eliminate, in the LLC context, a basic, centuries-old protection for shareholders, leaving the courts to devise some new substitute remedy.” Waving the separation of powers banner, the minority opinion accused the majority of “judicial fiat” by “effectively rewrit[ing] the law to add a right the Legislature deliberately chose to omit,” adding, “[t]he proponents of derivative rights for LLC members — who were unable to muster a majority in the Senate — have now obtained from the courts what they were unable to achieve democratically.” Judicial fiat or not, the derivative action in years since has become a favorite weapon in the arsenal of disputing LLC members.

2008: Dissolution Waiver Void as Against Public Policy. In Matter of Youngwall v. Youngwall Realty, LLC, Short Form Order, Index No. 22266/07 (Sup. Ct. Nassau County 2008), the court held that enforcement of an operating agreement’s provision waiving a member’s right to seek judicial dissolution, and forfeiting the interest of a member who does so, “is void and unenforceable as against public policy.” In so ruling the court followed the Second Department’s lead in Matter of Dissolution of Validation Review Associates [Berkun], 223 A.D.2d 134, 646 N.Y.S.2d 149 (2d Dept. 1996), likewise voiding as against public policy a similar provision in a shareholders’ agreement of a close corporation. The Youngwall decision puts New York law at odds with Delaware law as expounded by the Delaware Chancery Court in Huatuco v Satellite Healthcare, C.A. No. 8465-VCG (Del. Ch. 2013). In that case the court dismissed an LLC judicial dissolution complaint based on the operating agreement’s provision that “Members shall only have the power to exercise any and all rights expressly granted to the Members pursuant to the terms of this Agreement.” Chancery Court read the provision as an “opt[] out of the statutory default [authorizing an action for judicial dissolution] contained in 6 Del. C. § 18-802.”

2009: Common-Law Accounting Remedy Recognized. Unlike the Partnership Law, the LLC Law has no provision requiring managers to provide an accounting. In Gottlieb v Northriver Trading Co., 58 A.D.3d 550, 872 N.Y.S.2d 46 (1st Dept. 2009), the First Department gave life to an LLC member’s common-law right to seek an equitable accounting. The court’s decision adopted the Court of Appeals’ reasoning in Tzolis v Wolff finding a common-law right to sue derivatively on the LLC’s behalf.

2010: Member Expulsion Only if Authorized in the Operating Agreement. New York’s LLC Law, unlike the Revised Uniform LLC Act, does not provide for judicial expulsion of a member. In Chiu v. Chiu, 71 A.D.3d 646, 896 N.Y.S.2d 131 (2d Dept. 2010), the Second Department held that, while LLC Law Section 701 mentions member expulsion as an event triggering possible non-judicial dissolution, New York courts have neither statutory nor common-law authority to compel the expulsion of an LLC member absent an enabling provision in the operating agreement.

2010: Setting the Standard for LLC Dissolution Under Section 702. Matter of 1545 Ocean Avenue, LLC, 72 A.D.3d 121, 893 N.Y.S.2d 590 (2d Dept. 2010), far and away is the most consequential decision impacting judicial dissolution proceedings involving LLCs. There, the Second Department adopted a contract-centric approach that explicitly rejected the importation to the LLC Law of grounds for dissolution under the Business Corporation and Partnership Laws. Under Section 702 as interpreted by the Second Department, the petitioner “must establish, in the context of the terms of the operating agreement or articles of incorporation, that (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.” The standard has been adopted in courts throughout the state.

2013: Buyout an Appropriate Equitable Remedy in “Certain Circumstances”. In Mizrahi v Cohen, 104 A.D.3d 917, 961 N.Y.S.2d 538 (2d Dept. 2013), after the lower court found grounds for judicial dissolution under Section 702, over the respondent’s objection the Second Department authorized the petitioning 50% member to purchase the respondent’s 50% interest in the LLC “upon its dissolution,” explaining that “in certain circumstances, a buyout may be an appropriate equitable remedy upon the dissolution of an LLC” notwithstanding that the LLC Law has no provision authorizing a buyout. In the 10 years since Mizrahi, it appears that the lower courts have not been disposed to compel equitable buyouts absent the kind of peculiar facts operative in Mizrahi. But that could change.

2016: No Subject Matter Jurisdiction Over Foreign LLC Dissolution. In Matter of Raharney Capital, LLC, 138 A.D.3d 83, 25 N.Y.S.3d 217 (1st Dept. 2016), the First Department ended an inter-departmental split by agreeing with appellate decisions by the Second and Third Departments, ruling that New York courts lack subject matter jurisdiction over dissolution proceedings involving foreign entities including LLCs. Why subject matter jurisdiction and not inter-state comity, I can’t say.

2017: Post-Formation Operating Agreement Adopted by Majority Consent. In Shapiro v Ettenson, 146 A.D.3d 650, 45 N.Y.S.3d 439 (1st Dept. 2017), the First Department affirmed the lower court’s order insofar as it held that under LLC Law Section 402(c)(3)’s default rule, a majority in interest of the members can adopt an already-formed LLC’s operating agreement without the consent of the holder of a minority interest. In that case the operating agreement including mandatory capital call and other provisions opposed by the non-consenting member. The decision is a stark reminder to persons considering becoming a minority member of an LLC to negotiate up front and execute an operating agreement prior to the LLC’s formation.

2017: The Purposeless Purpose Clause. In Mace v Tunick, 153 A.D.3d 689, 60 N.Y.S.3d 314 (2d Dep. 2017), the Second Department affirmed that part of the lower court’s order holding that a purpose clause of the sort commonly used in operating agreements, stating that the LLC’s purpose was “to conduct any lawful business for which limited liability companies may be organized and to do all things necessary or useful in connection with the foregoing,” did not set forth “any particular purpose” for the subject LLC and therefore did not, as a matter of law, preclude a dissolution petition claiming that the LLC was no longer serving its intended purpose.

2017: No Standing to Sue Derivatively Upon Withdrawal. In Jacobs v Cartalemi, 156 A.D.3d 605, 67 N.Y.S.3d 63 (2d Dept. 2017), the Second Department affirmed the lower court’s order holding that a minority member who exercised his right to withdraw under pre-amendment LLC Law Section 606 was bound by the operating agreement’s right of first refusal and lost his standing to assert derivative claims “notwithstanding his possible right to a future payment for the value of his interest upon his withdrawal.”

2021: Alleged Unlawful Conduct No Basis to Challenge Cash-Out Merger. In Farro v Schochet, 190 A.D.3d 689, 140 N.Y.S.3d 524 (2d Dept. 2021), involving a cash-out merger that terminated the membership interest of a minority member, the Second Department held that under LLC Law Section 1002(g), an appraisal proceeding is the cashed-out member’s exclusive remedy and, in contradistinction to BCL Section 623(k)’s provision expressly allowing such challenges by shareholders of corporations, that “no exception exists for alleged fraud or illegality in the procurement of the merger.” The decision also held that LLC Law Section 407(a)’s default rule, authorizing action by written consent in lieu of meeting, trumps Section 1002(c)’s requirement to call a member meeting on no less than 20-days notice to vote on a proposed merger. The combined effect of the two holdings is that a minority member may not even be aware of a binding cash-out merger until after it’s consummated.

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