A Case of LLC Withdrawal Symptoms
January 27, 2020
I was especially drawn to the case I’m about to introduce involving LLC member withdrawal, owing to the Jacobs v Cartalemi case that I litigated to a successful conclusion about two years ago, also involving member withdrawal.
In Jacobs, the court held that a member who withdrew from the LLC as of right under the default statute, where the operating agreement was silent on withdrawal, nonetheless was obligated to comply with the operating agreement’s right of first refusal provision, thereby defeating the member’s statutory demand for payment of the fair value of his shares. The provision by its terms was triggered by a member who “desires to sell his, her or its Membership Interest,” which the court interpreted to encompass a member’s notice of withdrawal and demand for payment.
The Point 128 LLC v Choi, decided earlier this month by Manhattan Commercial Division Justice Andrea Masley, did not involve a formal withdrawal notice and demand for payment of fair value as in Jacobs. Rather, in Choi the question presented was whether attempts to obtain a buyout and the filing of a related lawsuit brought by the LLC’s minority members against the controlling members, sought to circumvent and breach the operating agreement’s anti-withdrawal provisions.
The Minority Members Demand a Buyout, Then Sue
The Point 128 LLC was formed in 2010 for the purpose of owning, developing, marketing, and leasing a five-story commercial property in College Point, New York. The defendants collectively acquired slightly less than 13% of the membership interests in the LLC and also acquired minority interests in the commercial lessee of the LLC for purposes of operating a hotel at the property.
According to the LLC’s complaint, following completion of the development phase the project’s leasing efforts fell short creating serious financial challenges. The complaint alleges that beginning in 2013 and over the next several years, the defendants became unhappy with their investment and presented highly inflated values of their combined interests in both the LLC and the hotel as the basis for their demands to be bought out.
In the midst of their unsuccessful buyout demands, in 2016 the defendants filed a suit for judicial dissolution of the LLC which they later discontinued. In 2018, they filed another lawsuit against the controlling members of the LLC (the “Related Action”), asserting both derivative and direct claims for breaches of fiduciary duty and the operating agreement, and seeking damages and an accounting.
The LLC Strikes Back
In 2019, the LLC filed a damages suit against all the defendants for breach of the operating agreement and against one of the defendants who was a managing member for breach of fiduciary duty. The LLC’s complaint describes the general basis for its claims as follows:
This action arises out of defendants’ breach of the Agreement by virtue of their willful disregard of the specified procedures necessary to duly effectuate a sale of their proprietary interest in the Company. Instead, defendants have filed a suit seeking purely to extract a buyout of their interests at an exorbitant, highly inflated and unreasonable valuation under the guise of a derivative action against the plaintiffs. The wrongful and improper actions of the defendants have resulted in the Company incurring legal and other expenses necessary to respond to the defendants’ cynical and exaggerated claims, a distraction and interruption of the Company’s ordinary and regular business operations, as well as damage to the Company’s goodwill and reputation by virtue of the baseless claims and false accusations made by the defendants.
The complaint specifically alleges defendants’ breaches of a number of provisions in the LLC’s operating agreement restricting a member’s right to withdraw and receive the value of its membership interest. They are:
- Section 3.3 (“Withdrawal of a Member”) prohibiting member withdrawal except with the consent of the majority of the members, and in such event entitling the withdrawn member to be paid a pro rata percentage of the “current fair market value of the total assets of the Company which shall be determined by a real estate appraisal conducted by an appraiser mutually appointed by the withdrawing Member and the Company.”
- Section 4.4 (“Restrictions on the Members”) providing that, except with the requisite managerial consent, a member shall not “pledge or otherwise dispose of his or her interest in the Company . . . or enter into any agreement as a result of which any other person shall have rights as a Member of the Company,” and that “No member shall do any act in contravention of [the Operating Agreement}.”
- Section 8.2 (“Violation of Restrictions”) providing that any “disposition” of a member’s interest without the other members’ consent will be treated as a withdrawal and the disposer of interest shall be deemed “terminated” giving the other members the option to purchase their interest at fair market value as provided in Section 3.3.
The Court Denies Defendants’ Dismissal Motion
The defendants moved to dismiss the complaint on a number of grounds, including failure to state a valid claim for breach of the operating agreement based on their efforts to achieve a buyout and the Related Action brought against the controllers.
In essence, the defendants argued, first, that the operating agreement’s restrictions on a member’s withdrawal rights did not come into play because the defendants allegedly sought to sell their membership interests, not withdraw from the LLC. Second, they argued that nothing in the operating agreement barred them from filing the Related Action against the LLC or its managing members. Third, they contended that they did seek the other members’ consent to sell their interests as allegedly evidenced by certain emails.
Justice Masley did not agree, writing:
Affording the complaint its most liberal construction, Point 128 adequately asserts a claim for breach of the [operating agreement] in that it alleges that defendants impermissibly sought to circumvent and breached the [operating agreement] in attempting to use the Related Action to dispose of their membership interests in Point 128.
She also specifically rejected the defendants’ distinction between a member who seeks to sell its interest versus withdraw, writing:
While the term “withdraw” is not defined in the [operating agreement], it is only feasible for a member to withdraw its membership interest from Point 128 in certain limited ways: by relinquishing its interest in whole by transfer, sale, or other disposition . . .. While the court deems § 3.3 unambiguous on its face, the lack of a definition for the term “withdraw” would otherwise create an ambiguity and render this prong of defendants’ motion unfit for disposition on a motion to dismiss. . . .
. . . Point 128 sufficiently asserts at least a claim for breach of the [operating agreement] against defendants in that they violated § 4.4 (b) in seeking to circumvent §§ 3.3, 4.4 (a), 8.1 and/or 8.3 by disposing of their membership interests without the consent of all members in commencing the elated Action to force a buy out on favorable terms.
Finally, Justice Masley also rejected defendants’ arguments that the Related Action’s claims could not be construed as a means by which to extract a buyout and dispose of their membership interests, and that the emails they sent the managing members “irrefutably” demonstrate that the defendants sought or obtained consent to dispose of their interests.
I’m not surprised by the outcome in Choi. In the Jacobs case, the court likewise adopted the corollary proposition that a member’s withdrawal from the LLC and demand for payment was the equivalent of a member who “desires to sell his, her or its Membership Interest” as that phrase was used in the operating agreement’s right of first refusal provision. The Choi case also contains echoes of decisions I’ve written about involving close corporations with shareholder agreements containing compulsory or optional buyout provisions for shareholders who seek to “dispose” of their stock which, depending on the breadth of the wording used, courts on occasion have held are triggered by the filing of a petition for judicial dissolution.