Beware Diversity Trap in Federal Court Business Divorce Cases Involving LLCs

April 03, 2017

I can count on one hand the number of federal court cases I’ve featured on this blog since I started it almost 10 years ago — and that’s no coincidence.

Federal courts are courts of limited jurisdiction, requiring either the presence of a claim arising under federal law — so-called federal question jurisdiction — or the opposing litigants are citizens of different states — so-called diversity jurisdiction.

Federal question jurisdiction rarely exists in business divorce cases involving the internal affairs of closely held business entities which are the peculiar province of state law. Federal courts are especially loathe to decide judicial dissolution cases, to the point where they routinely exercise their discretionary power to abstain from exercising jurisdiction even in dissolution cases where diversity exists (read here).

Inevitably there are some small number of diversity suits filed in federal court asserting state-law claims other than dissolution between business co-owners. Even in these cases, however, there is a potential trap for the unwary plaintiff if the subject business entity is a limited liability company, as nicely illustrated by a Manhattan federal judge’s decision last month in Sullivan v Ruvoldt, Opinion and Order, 16 Civ. 583 [SDNY Mar. 24, 2017].

Case Background

Sullivan involves a law firm formed in late 2013 by two individuals as 50/50 members of a New York professional limited liability company called Sullivan Ruvoldt PLLC. They had no written operating agreement. In March 2015, Sullivan announced he’d accepted a government job in Vermont starting the next month. Sullivan and Ruvoldt exchanged a series of seven, back-and-forth emails discussing Sullivan’s withdrawal from the PLLC and the logistics and financial terms of his departure, but nothing definitive came of it.

On April 1, 2015, Ruvoldt posted on the firm’s website an announcement of Sullivan’s departure and that the firm had changed its name to Fleming Ruvoldt PLLC.

A month later, Sullivan filed suit against Ruvoldt, Fleming, and Fleming Ruvoldt PLLC in federal court in Florida where the firm had previously opened a satellite office, asserting claims for an accounting plus declaratory and injunctive relief. The suit accused the defendants of commingling the funds of the former Sullivan Ruvoldt and new Fleming Ruvoldt firms — even though legally they were the same entity — and taking Sullivan’s property without authority.

Sullivan’s complaint alleged complete diversity of citizenship as the basis for federal court jurisdiction based on allegations that Sullivan was a resident and citizen of Vermont, Ruvoldt and Fleming residents and citizens of New Jersey, and Fleming Ruvoldt PLLC a New York citizen.

In early 2016, the Florida court granted the defendants’ motion to transfer the case to the Southern District of New York based on forum non conveniens. After the transfer, the defendants moved to dismiss the case on several grounds, starting with lack of jurisdiction based on non-diversity of citizenship.

The LLC Diversity Trap

Article III, Section 2 of the U.S. Constitution gives federal courts jurisdiction in “Controversies . . . between Citizens of different States.” Diversity jurisdiction is codified in 28 U.S.C. § 1332 which specifically deems a “corporation” to be a citizen of its state of incorporation as well as the state in which it has its principal place of business. The statute does not define the citizenship of unincorporated entities, including limited partnerships and LLCs.

In 1990, the U.S. Supreme Court decided Carden v Arkoma Associates in which it refused to extend § 1332’s definition of corporation citizenship to a limited partnership, instead holding that the citizenship of a limited partnership and its constituent partners is one and the same.

Subsequently, federal district and intermediate appellate courts, including the U.S. Court of Appeals for the Second Circuit in Handelsman v Bedford Village Associates, L.P., applied Carden‘s logic to LLCs, holding that they too have the same citizenship as all their members.

Therein lies the trap. Let’s say John Smith, a citizen of Connecticut, along with Jane Doe, a citizen of New Jersey, are co-members of Generic LLC, a New York limited liability company. John brings a diversity suit against Jane in federal court for wasting or looting company assets, or violating his rights under the operating agreement. He also names Generic LLC as defendant, either on a direct claim for monies owed him by the LLC and/or because he’s asserting derivative claims on its behalf.

John may think there’s diversity for jurisdictional purposes, but he’s wrong. In the post-Carden era, Generic LLC is deemed to be a citizen of both New Jersey (where Jane resides) and Connecticut (where John resides), hence complete diversity is lacking since John on the plaintiff side and Generic LLC on the defendant side both are Connecticut citizens.

Lack of Diversity in Sullivan

In Sullivan, unlike in numerous other cases I’ve seen with unwary plaintiffs suing LLCs in which they have a membership interest, there’s no reason to think that the plaintiff was aware or unaware of the Carden rule. Rather, the plaintiff in Sullivan apparently felt secure in his allegation of diverse citizenship on the premise that he had withdrawn from Fleming Ruvoldt PLLC f/k/a Sullivan Ruvoldt PLLC when he left to take a Vermont government job, and was no longer a member.

In support of their dismissal motion for lack of jurisdiction, and notwithstanding the public announcement on the firm’s website of Sullivan’s departure, the defendants took the position that Sullivan never stopped being a member of the PLLC because he did not formally withdraw from membership in accordance with the governing default rules of New York’s LLC Law. As U.S. District Judge Edgardo Ramos summed up the critical issue, “if Sullivan remains a member of Fleming Ruvoldt PLLC, Fleming Ruvoldt PLLC would also be a Vermont citizen and diversity jurisdiction would be lacking.”

Which is exactly the conclusion reached by Judge Ramos, whose analysis focuses on the default rule governing member withdrawal in LLC Law § 606 (a). The section permits a member to withdraw prior to dissolution only when and in the manner authorized by the LLC’s operating agreement.

Sullivan argued that his email exchange with Ruvoldt prior to his departure constituted a one-topic, written “operating agreement” that provided for his right of withdrawal, however Judge Ramos, applying standard contract analysis concerning offer and acceptance, didn’t buy it, writing as follows:

The seven emails between Sullivan and Ruvoldt do not show that there was an acceptance of an offer, and indeed, establish that the terms of the withdrawal were not finalized. Ruvoldt’s initial email on March 26, 2015 at 9:58 a.m. stated inter alia that Sullivan would need to “formally withdraw,” that “[Sullivan’s] interest will be set as assets minus liabilities at Midnight 3/31,” and that Ruvoldt will “manage the wind down.” At the end of the email, Ruvoldt asked Sullivan to “email back that this is agreeable.” However, nowhere in the three emails subsequently sent by Sullivan was there an affirmative acceptance of Ruvoldt’s “offer.” [Citations omitted.] . . .

. . . [I]n the absence of some other written agreement providing for Sullivan’s withdrawal, NYLLCL does not allow Sullivan to withdraw from the firm prior to dissolution. The Court finds that Sullivan remains a member of Fleming Ruvoldt PLLC, and thus, there is no complete diversity among the parties.

Notice how Judge Ramos emphasizes the word “written” in the phrase “written agreement.” New York’s LLC Law § 102 (u), unlike counterpart statutes in many if not most other states allowing written, oral, or even implied operating agreements, defines an operating agreement as “any written agreement of the members concerning the business of a limited liability company and the conduct of its affairs.”

For that very reason, Judge Ramos also rejected Sullivan’s alternative argument that the parties’ course of conduct after he took the Vermont job — presumably referring not only to his termination of employment but also the firm’s change of name and Ruvoldt’s opening of new bank accounts for the “new” firm — was adequate proof of an agreement permitting Sullivan’s withdrawal.

The dismissal of Sullivan’s suit for lack of jurisdiction represents almost two years of litigation up in smoke, forcing him to start anew presumably in New York state court. Indeed, any idea Sullivan may still have about suing elsewhere now has to contend with a preemptive strike in the form of a summons with notice filed by Ruvoldt in New York state court only three days after Judge Ramos’s decision, naming Sullivan as defendant and seeking damages for breach of fiduciary duty and to recover litigation costs in the federal suit.