The Bad-Faith Petitioner Defense Makes Successful Debut in LLC Dissolution Case

February 04, 2019

What’s become known as the bad-faith petitioner defense in judicial dissolution proceedings first emerged in Matter of Kemp & Beatley, 64 NY2d 63 [1984], where the Court of Appeals in a minority stockholder oppression case wrote that “the minority shareholder whose own acts, made in bad faith and undertaken with a view toward forcing an involuntary dissolution, give rise to the complained-of oppression should be given no quarter in the statutory protection.”

It took several decades, but eventually the bad-faith petitioner defense made a salutary species jump to deadlock dissolution cases involving 50/50 shareholders as a result of Justice Vito DeStefano’s thoughtful analysis in Feinberg v Silverberg.

Kemp and Feinberg both involved judicial dissolution of closely held corporations governed by Article 11 of the Business Corporation Law. As I noted in a post a couple of years ago describing a Tennessee case in which the court found that the petitioner seeking dissolution of a Delaware LLC had “manufactured” the alleged impasse between 50/50 members, I’ve patiently been awaiting another species jump to dissolution proceedings under Section 702 of New York’s LLC Law.

My patience was rewarded last month, when Manhattan Commercial Division Justice Saliann Scarpulla confirmed a special referee’s report and dismissed a Section 702 dissolution petition by a 50% co-managing member of a realty holding LLC based on his own conduct in breach of the operating agreement designed to “force dissolution” and “push” the other husband-and-wife members “out of the building.” Advanced 23, LLC v Chambers House Partners, LLC, 2019 NY Slip Op 30173(U) [Sup Ct NY County Jan. 22, 2019].

Background

This is Advanced 23‘s second appearance on this blog. A year ago I reported on Justice Scarpulla’s rulings rejecting respondents’ argument for dismissal of the petition based on the operating agreement’s provision stating that the LLC “will be dissolved only upon the unanimous determination of the Members to dissolve,” and directing an evidentiary hearing before a special referee to determine whether the petitioner breached his duties and obligations under the operating agreement “to force dissolution.”

A three-day hearing was held before Special Referee Deborah Edelman who issued a detailed, 31-page Report and Recommendation dated October 5, 2018. The Report describes the LLC’s sole asset as a five-story mixed use building in lower Manhattan in which the petitioner, who purchased his 50% interest in 2013 from a previous owner for $1.8 million, and the elderly husband (94 years old) and wife (81 years old) respondents, who together owned a 50% interest since the LLC’s formation some years before, each maintained a full-floor residence. Suffice it to say, their relationship was less than neighborly including an incident concerning trash disposal in which the petitioner was found to have hit the wife with a piece of cardboard.

The petition (read here) alleged that the respondents engaged in an “aggressive pattern of harassment” against the petitioner’s live-in girlfriend and that, following a disagreement over refinancing the building’s mortgage, the respondents threatened to sue petitioner and without authorization opened a new bank account under their exclusive control into which they transferred LLC funds. The respondents’ answer (read here) accused petitioner of scheming to force them into a sale of their membership interest and pleaded as an affirmative defense that the petitioner “wrongfully manufactured” his claims “in order to qualify for dissolution pursuant to LLC Law § 702” and “wrongfully created the basis for this proceeding in retaliation for respondents not permitting [petitioner] to recoup his investment in [the LLC] by obtaining a $4,000,000 mortgage.”

The Special Referee’s Findings

The Special Referee credited respondents’ testimony concerning the petitioner’s breach of the operating agreement’s requirement for monthly meetings of the managers, but nonetheless found that this particular breach was not done to force dissolution.

The Special Referee reached a different conclusion in regard to petitioner’s refusal to extend or refinance the property’s balloon mortgage over $500,000 which came due in December 2015. The parties gave sharply conflicting accounts of a climactic meeting, also attended by respondents’ lawyer, that took place in October 2015. The Special Referee gave especial credence to the lawyer’s testimony that, after he asked the petitioner for the name of his mortgage banker,

[the petitioner] just looked at me, didn’t say a word, . . . he got up from his chair, and he turned to go to the door. And I said, You know the mortgage is coming up in six weeks. What happens if the [respondents] can’t pay it because I didn’t think they had any money when I agreed to take it. So he said, Well they’re just going to have to sell their place. I said, You know you are going to start a lawsuit here, to enforce your [mortgage loan] guarantee, you’re going to start it. He turned to me, he said, Well, so what? And he went to the door.

The petitioner testified that he had regular meetings with the respondents in the months leading up to the October meeting and that, whereas the respondents wanted to refinance the property with a maximum $1 million loan, he desired to borrow $2 million to $4 million and to use the excess funds for other investments. He also testified that he left the October meeting because respondents and their lawyer threatened to sue him.

The Special Referee found petitioner’s testimony not credible and that “his demeanor shifted between smug and vindictive.” She then found that, in addition to breaching the operating agreement’s requirement to hold monthly management meetings, that the petitioner “was acting in breach of his duties of good faith and ordinary care to preserve and support the stated business purpose of [the LLC]” which included “to provide a residence for its Members.”

The Special Referee’s next, critical finding was that the petitioner breached his obligation under the operating agreement to attempt to resolve the deadlock over the mortgage refinancing, first, by informal mediation and, second, by binding arbitration. Instead of complying, she found, the petitioner “unilaterally informed [the mortgage lender] that there would be no mortgage extension” and that, after the respondents came up with their share of the mortgage payoff, he sought to dissolve the LLC. “I report and recommend finding,” the Special Referee concluded,

that [the petitioner] was, at some point prior to the October 16, 2015 meeting, trying to push the [respondents] out of the Building. I therefore, report and recommend that [the petitioner] committed the above breaches of the Operating Agreement to attempt to force dissolution of [the LLC].

The Special Referee also found two additional breaches by petitioner designed to force a dissolution. First, after filing his dissolution petition, the petitioner breached the operating agreement’s provisions requiring the co-managers to make monthly and year end distributions to the members. Second, he sought to unilaterally dissolve the LLC “despite clear language to the contrary in the Operating Agreement” requiring unanimous agreement of the members to dissolve and requiring arbitration should members be unable to reach agreement.

Confirmation of the Report

In her brief order confirming the Report and denying petitioner’s request to dissolve the LLC, Justice Scarpulla found that the Special Referee’s finding, based on “credibility determinations among the respective parties’ testimony,” that petitioner breached the operating agreement to force a dissolution was “substantially supported by the record.”

Justice Scarpulla expressed her opinion more openly at the oral argument of the parties’ dueling motions to confirm and reject the Report, where she stated at pages 9-10 of the transcript:

I wanted to know what [petitioner] was — whether or not this was an inducement. That’s been [respondents’] claim the whole time. That he has tried — these are two older people. He invests in this property thinking I’m going to kick them out, make them sell the property and take it myself. That’s been their claim the whole time. He knows it, you know it, counsel knows it, I know it. And I wanted to know does that claim hold water. And the referee said yes, it does.

Some of you may have noticed that the above account of the case proceedings nowhere mentions any legal argument or analysis by the parties or the court concerning the bad-faith petitioner defense and its applicability to dissolution proceedings under Section 702 of the LLC Law. Truth be told, in the court filings I read, including the parties’ post-hearing briefs, I saw no citation to cases decided under the Business Corporation Law’s dissolution statutes upholding the bad-faith petitioner defense.

I’m nonetheless comfortable classifying Advanced 23 as an example of the bad-faith petitioner defense’s application in an LLC dissolution case. The Special Referee found that the petitioner’s unreasonable and deliberate breaches of the operating agreement were designed to “force” dissolution and “push out” the respondents. Such findings accord with the language and logic of the Court of Appeals’ dicta in Kemp, that the petitioner’s “own acts, made in bad faith and undertaken with a view toward forcing an involuntary dissolution . . . should be given no quarter in the statutory protection,” as well as Justice DeStefano’s reasoning in Feinberg that “a manufactured dissension would belie a finding that the shareholders’ dissension poses an irreconcilable barrier to the continued functioning and prosperity of the corporation.”