And a Time to Every Purpose Under . . . the Operating Agreement?

November 21, 2022

King Solomon, to whom authorship of Ecclesiastes 3 traditionally is attributed, unlikely had in mind the life cycle of limited liability companies when he wrote, “To every thing there is a season, and a time to every purpose under the heaven, A time to be born, and a time to die . . ..”

It’s a bit of a stretch to suggest that King Solomon prophesied the standard for judicial dissolution of LLCs, but there it is: under New York’s judicially construed standard for involuntary dissolution under Section 702 of the LLC Law, an LLC whose management “is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved,” is destined for the chopping block.

The standard’s focus on the achievement or not of the LLC’s “stated purpose” has taken center stage in many an LLC dissolution case (and many a post on this blog, e.g., here, here, and here). A good number of these cases involve real estate holding companies whose operating agreements state the LLC’s purpose to acquire, own, develop, manage, lease, and sell (or other, similar terms) a specified real property.

Chernomordik v Ocean Sand Development, LLC, decided earlier this month by Brooklyn Commercial Division Justice Leon Ruchelsman, presents one of the more intriguing examples of a dissolution case highlighting the centrality of the purpose clause in a realty holding LLC’s operating agreement.

The LLC

The complaint in Chernomordik describes Ocean Sand Development LLC as having been formed in New York in 2007 for the purpose of developing an oceanfront condominium community in Cabarette, Dominican Republic. “As planned,” the complaint alleges, “the Development Project was to consist of six four-story buildings, situated on a 14-acre lot straddling the Atlantic Ocean, consisting of a total 140 condominium residences and 14 townhouses, as well as a spa & leisure facility, a fitness center, restaurants, tennis courts, swimming pool and a community center.”

The complaint alleges that plaintiff Mark Chernomordik paid $400,000 for a 5% membership interest and that defendant/managing member Aleksander Goldin holds a 48% interest “and controls all decisions concerning Ocean Sand’s activities.”

The Operating Agreement

Ocean Sand’s operating agreement features a “Preliminary Statement” that reads,

The parties to this Agreement have elected to create a limited liability company within the ambit of the New York Limited Liability Company Law to own, lease, develop, manage, and operate the premises located at Cabarette, Dominican Republic (the “Property”), and to engage in such other lawful activities for which Limited Liability Companies may be organized under the laws of the State of New York.

Section 2.4 provides that the “term of the Company shall be perpetual.”

Section 2.5, captioned “Purposes,” states that “[s]ubject to the provisions of this Agreement, the purposes of the Company are “to purchase, lease or otherwise acquire, and to hold, develop, use, lease, licenses [sic], maintain, sell, and otherwise deal with the Property”; to borrow funds and issue mortgages “in furtherance of any and all the objects of the business of the Company”; and “to do any and all other acts and things which may be necessary, incidental or convenient to carry on the business of the Company.”

The purpose clause also includes what I have called in previous posts the “purposeless” purpose clause, to wit, “to engage in any lawful act or activity for which Limited Liability companies may be formed in New York.”

The events of dissolution specified in Section 10.1 include “the date on which the Company ceases doing business for any reason.”

The Lawsuit

The complaint alleges that since the purchase of the Property in 2007 there has been no construction work whatsoever; that the land has stood barren and undeveloped ever since; that Goldin as Managing Member blamed it on the LLC’s inability to obtain the necessary permits; that the failure for 13 years to obtain the necessary permits indicates that there is no remotely reasonable prospect of ever obtaining them; and that the development project is effectively dead and the business of the company, as it was intended by the plaintiff and other members, “is for all intents and purposes, nonexistent.”

In addition to seeking dissolution of Ocean Sands and the liquidation of its assets, the complaint asserted causes of action for breach of contract, breach of fiduciary duty, and an accounting. The latter causes of action, which I’m otherwise ignoring in this post, are primarily based on a 2011 letter agreement in which the LLC agreed to pay Chernomordik interest at 10% on a portion of his “pre-construction deposit” used to acquire additional land.

The Dismissal Motion

The LLC and Goldin filed a pre-answer motion to dismiss the complaint. Primarily they argued that the operating agreement contradicted the complaint’s allegation that the LLC’s business was limited to the condominium development project in the Dominican Republic, that the LLC never committed to proceed with the project by any particular deadline, and that the “mere fact” that it has taken 15 years to get a permit from the Dominican Republic’s Ministry of the Environment does not necessarily support plaintiff’s assertion that there is no reasonable prospect that the project would ever go forward.

The defendants argued that the operating agreement’s purpose clause broadly authorizes the LLC to acquire any properties, i.e., not just the Dominican Republic project. They also pointed to the purpose clause’s “engage in any lawful act or activity” provision and the LLC’s perpetual term as not requiring it to develop the land or do anything else within any particular period of time.

In opposition, Chernomordik cited the complaint’s allegations that:

the LLC’s 2014 tax return reported that the project had been “abandoned” for which it took a loss;
the LLC took down its website for which it also took a tax loss;
ground has not been broken and the land sits empty since its acquisition;
the government authorities in the Dominican Republic denied the required environmental permit three times, most recently in 2012;
the LLC’s liabilities exceed its assets by over $2 million; and
the investors’ capital accounts are being gradually depleted.

Chernomordik argued that to hold the land indefinitely without developing it cannot plausibly be deemed the LLC’s “business” as that term is used in the operating agreement’s purpose clause. He also argued that to accept defendants’ argument based on the purpose clause’s “engage in any lawful act or activity” provision would render the term “business” meaningless as used in Section 10.1 providing for dissolution when the LLC “ceases to do business.” Chernomordik argued that dissolution was warranted both contractually under Section 10.1 and judicially under Section 702 of the LLC Law.

The Court’s Decision

Justice Ruchelsman’s legal analysis does not mention Chernomordik’s contractual argument for dissolution under Section 10.1 and instead focuses exclusively on the statutory standard for judicial dissolution under LLC Law Section 7O2, requiring proof that it is “not reasonably practicable to carry on [the LLC’s] business in conformity with the articles of organization or operating agreement.”

Justice Ruchelsman also invokes the prevailing judicial interpretation of the statutory language, requiring the plaintiff to establish that management is “unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved” or that “continuing the entity is financially unfeasible.”

Justice Ruchelsman quotes from the operating agreement’s Preliminary Statement and Section 2.5 purpose clause before noting the Dominican Republic’s serial rejections of the LLC’s development plans. He was not persuaded, however, by the defendants’ plea that the “best option going forward is to ‘continue to hold the Property with the reasonable expectation that its value will skyrocket if and when the regulatory environment changes, as it tends to do from time to time in the Dominican Republic.’” Rather, the judge wrote,

that option is so speculative, so abstract and so theoretical and its success is not dependent upon the efforts of any of the parties but upon policy changes in a foreign government. While arguments the entity cannot conduct its business might be premature since the property is still being held by the entity, there can be no question the goal of the entity was not to hold the undeveloped property for such a long period of time.

Although the LLC “has been forced to maintain the property in its current undeveloped state due to conditions beyond its control,” he continues, “[t]hat does not mean the entity is legitimately pursuing the goals of the operating agreement.” Rather,

the entity is trying to cope with the best of a bad situation. Therefore, there are surely questions whether the entity can ever achieve the goal of developing the property. Thus, the plaintiff may be able to establish the stated goal of the entity will never be achieved.

The defendants stress that dissolution would destroy any chance of ever recovering initial investments and that really the only option is to wait and hope for the ability to develop the property in the future. While that may be true, as noted, that may never happen. Thus, further discovery and an eventual trial is necessary to evaluate the ability to sell the property, the advantages that may be gained from owning the adjoining properties and the harsh reality the property may never be developed. Therefore, the motion seeking to dismiss the dissolution claim is denied.

Purposing the Single-Asset Realty Holding LLC

I’ve come across and written about many operating agreements — mainly with companies engaged in manufacturing, sales, and services — that simply state as the LLC’s purpose that the company is formed for “any valid business purpose.” Purpose clauses of the sort make it more difficult for a dissident minority member to establish grounds for judicial dissolution.

That’s not to say an “any valid business purpose” clause won’t reach the same result when included in the operating agreement of a single-asset realty holding LLC. In the Ross case that I wrote about some years ago, the court dismissed a dissolution petition involving an LLC that sold its sole realty asset and then reinvested the proceeds in another property over the objection of a minority member who argued that the sale had extinguished the LLC’s original purpose.

Generally, though, it’s quite common to find single-asset realty holding LLC’s with purpose clauses that eschew the all-encompassing “any valid business purpose” and instead identify the specific property to be acquired, possibly developed, managed, leased, mortgaged, etc. One possible reason for that is the typical inclusion in operating agreements of single-asset realty holding LLCs a provision that permits the members to invest and participate in other real estate ventures, including competitive ones, without breaching any duty owed to the LLC and its other members.

In other words, by narrowing the LLC’s purpose to the single property, it’s that much harder for one member to accuse another of some act of disloyalty or usurpation of a company opportunity. The purpose clause in Chernomordik, which included the specific along with the all-encompassing “any valid business purpose,” is less common in my experience and, as seen in the court’s decision, less likely to provide a defense to a minority member’s dissolution action.