Can LLC Agreement Waive Right to Sue Derivatively? Not in These Two Cases
April 23, 2018
Recently, in two separate cases, two New York judges construing two LLC agreements of two LLCs formed under the laws of two different states — Delaware and Nevada — came to the same conclusion when faced with the same argument by the LLCs’ controllers who contended that minority members waived the right to institute litigation asserting derivative claims based on provisions in the agreements requiring managerial or member consent to bring an action on behalf of the company.
In both cases, the judges rejected the waiver argument after finding that the language of the provisions upon which the controllers relied did not expressly prohibit derivative claims. The more interesting question not reached, at least in the case of the Delaware LLC for reasons I’ll explain below, is whether the statute authorizing derivative claims is mandatory or permissive.
The first case, Talking Capital LLC v Omanoff, 2018 NY Slip Op 30332(U) [Sup Ct NY County Feb. 23, 2018], involves a New York-based, three-member Delaware LLC in the factoring business, providing financing to telecommunications firms that route international calls. The suit was filed by one of the members against the other two and their principals, at heart alleging derivative claims for usurpation of business opportunity, breach of the LLC agreement, and breach of fiduciary duty by forming a competing entity in league with the LLC’s third-party lender.
The defendant members and the lender moved to dismiss the complaint on jurisdictional and other grounds that occupy most of the discussion in Manhattan Commercial Division Justice Shirley Werner Kornreich’s 31-page decision. The only ground for dismissal I’ll mention here, the discussion of which begins on page 21 of the decision, concerns the defendant members’ contention that the plaintiff member lacked standing to assert derivative claims based on provisions in the LLC agreement requiring unanimous consent before members may act on behalf of the LLC.
The LLC agreement established a corporate-style board of managers consisting of the three principals of the three members. Section 5.2 (“Meetings of Board of Managers”) included the following provision requiring unanimous consent of the managers:
Notwithstanding anything to the contrary set forth herein, it is agreed and understood that the affirmative vote, consent or approval of all the Managers is required for every act or decision done or made by the Board of Managers unless a majority of those present of three members are present authorize one member to take action in a specific matter.
Relatedly, Section 5.4 (“Powers of Managers”) granted the Board of Managers the power and authority, in subsection (a) (xvii), “[t]o authorize any member, officer or other agent of the Board of Managers or agent or employee of the Company to act for and on behalf of the Company in all matters incidental” to the other, broad powers granted in that section.
The defendant members’ argument, that by these provisions the members waived the right under § 18-1001 of the Delaware LLC Act to bring a derivative action on behalf of the LLC, garnered a frosty reception from Justice Kornreich, who described it as one that “would inherently immunize managing members who commit wrongdoing.”
Her rejection of the argument, however, was based on a much narrower, textual analysis of the “general unanimous consent provision that does not expressly address the subject” of derivative claims and, more specifically, failed to express an agreement by the members “not to sue derivatively if bad faith and circumstances of demand futility are present.”
Justice Kornreich’s decision noted the absence of any supporting Delaware case authority cited in the defendants’ brief, and distinguished their reliance on the Delaware Chancery Court’s 2008 ruling in R&R Capital, LLC v Buck & Doe Run Valley Farms, LLC, about which I wrote here, in which the court enforced an LLC agreement’s provision explicitly waiving the right to seek judicial dissolution.
Which brings us to the most tantalizing part of the decision in which Justice Kornreich raised but explicitly refrained from expressing any opinion whether, under Delaware law, an LLC agreement ever can disclaim the right to sue derivatively. “Notably,” she observed, “the portion of the Delaware LLC law that addresses a member’s right to sue derivatively upon a showing of demand futility . . . is not prefaced by the ‘magical phrase’ of ‘[u]nless otherwise provided’ in the operating agreement,” thus “the question of whether § 18-1001 is mandatory or permissive is not clear.”
In R&R Capital, cited by Justice Kornreich in the preceding portion of her opinion, the court enforced an express waiver of the right to seek judicial dissolution under § 18-802 of the Delaware LLC Act which, like § 18-1001 authorizing derivative actions, lacks the “magical” phrase, “unless otherwise provided” in the LLC agreement. On the other hand, the court in R&R Capital also deemed important that waiver of the right to seek dissolution “would not leave an LLC member inequitably remediless” which, at least arguably, would not be the case with an express waiver of the right to bring derivative claims on the LLC’s behalf. We’ll just have to wait and see how the Delaware Chancery Court handles the issue if and when it arises.
Human Nature Las Vegas
The second case, decided a month later by Manhattan Supreme Court Justice Melissa A. Crane, did not have to wrestle with the permissive-versus-mandatory question as in Talking Capital for the simple reason that the Nevada LLC statute at play in Human Nature Las Vegas Inc. v Gildea, 2018 NY Slip Op 30507(U) [Sup Ct NY County Mar. 23, 2018], expressly casts a member’s right to bring a derivative action as a default rule (“unless otherwise prohibited by the . . . operating agreement”) subject to elimination in the LLC agreement.
Human Nature Las Vegas involves a Nevada LLC formed to engage in various business activities of an Australian musical group called Human Nature. One of the members brought suit in New York asserting derivative claims against two of the LLC’s managers allegedly for misappropriating $1.4 million. The plaintiff’s initial complaint pleaded demand futility but subsequently made a demand which was refused, after which the plaintiff filed an amended complaint so alleging.
The defendants moved to dismiss the suit for lack of standing based on Section 5.2 (k) of the LLC agreement, providing that “at least a majority” of the three managers “must approve” certain “key decisions” including any decision to “commence or settle any litigation or arbitration or hire or terminate any counsel in connection with such litigation or arbitration.”
Justice Crane quickly dispatched the defendants’ lack-of-standing argument, holding that “nothing in the operating agreement prohibits a derivative action” and that the “must approve” requirement in Section 5.2 (k) “in the context of approving a lawsuit generally does not mean the parties contemplated to ‘otherwise prohibit’ a derivative suit where demand has been refused.”
In other words, while Nevada law will enforce an LLC agreement’s waiver of the right to bring a derivative action, this particular LLC agreement didn’t do the trick.
What About New York Law?
I’m not aware of any cases testing the proposition whether, under New York law, a court can or cannot enforce an express waiver in the operating agreement of the right to bring a derivative action.
There’s an important difference between New York’s LLC Law and its Delaware and Nevada counterparts. Unlike those states, New York’s LLC Law omits any provision authorizing a derivative action. Rather, the right to do so in New York derives from common law as recognized in 2008 by New York’s highest court in Tzolis v Wolff.
One could argue, under the banner of freedom-of-contract, that the common-law roots of the LLC derivative action in New York should not preclude members of an LLC effectively from agreeing to waive the right to bring a derivative action. On the other side of the argument, one could point to New York case law holding (contrary to Delaware law as laid down in R&R Capital) void as against public policy a waiver of the right to seek judicial dissolution, to make the same argument as concerns the right to bring derivative litigation.
That’ll have to be another case for another day for another post on this blog.
P.S. My friend and former colleague Ethan Kobre, now a partner at the Schwartz Sladkus firm, after reading this post alerted me to an appellate ruling he won last year in Ridinger v West Chelsea Development Partners, LLC, in which the court reinstated dismissed derivative claims brought on behalf of condominium unit holders. The lower court had ruled that a prior release signed by the plaintiff, which included a covenant not to sue directly or derivatively, barred the action. The appellate court disagreed, holding that the “plaintiff could not and did not release the derivative claims on behalf of the unit owners,” although by bringing the action it exposed her “to a possible claim for damages for breach of the covenant.” A condominium is not an LLC, and a release is not an operating agreement, but the court’s “could not . . . release” comment is an interesting one in the LLC context as well.