Court Grants 50% LLC Member Derivative Right to Defend Action Brought by Other 50% Member’s Solely Owned Company
April 30, 2018
You know there’s something unusual going on in a case involving a dispute between co-members of an LLC — a form of business entity that didn’t exist in New York until 1994 — when the key legal precedents cited in the parties’ briefs date from the nineteenth and early twentieth centuries.
By any measure, Horowitz v Montauk U.S.A., LLC, No. 16-3912 [2d Cir. Apr. 20, 2018], is an unusual case, stemming from a fiercely contentious battle between 50/50 co-owners for control of a highly successful restaurant and night spot called The Sloppy Tuna located on the beach in Montauk, New York, a popular summer resort on the eastern tip of Long Island. The dispute, which is still going strong after four years, has spawned at least a half dozen lawsuits in state and federal courts in New York and Georgia, and landed operational control of The Sloppy Tuna in the hands of a court-appointed receiver.
Horowitz is a lawsuit brought in federal court by one of The Sloppy Tuna’s 50% members (Member #1) seeking injunctive relief and damages against the restaurant entity, a New York LLC (Restaurant), for trademark infringement based on the alleged unauthorized use of various trademarks and domain names related to The Sloppy Tuna that Member #1 registered in the name of his solely-owned company (Montauk).
The threshold issue teed up for the court in Horowitz — this post won’t address the several other issues addressed in the court’s opinion — and the reason I call the case unusual, is whether the Restaurant’s other 50% member (Member #2), who was not named as a party to the trademark action and who did not move to intervene in the action personally, under governing New York law has the right to defend the suit derivatively on behalf of the Restaurant.
That’s right, derivative defense, not derivative claim, the latter being the familiar type of litigation embodied in statute and invariably associated with challenges to actions or omissions by company management brought by non-controlling equity holders seeking remedies on the company’s behalf. I don’t know about you, but for decades I’ve been closely following case law in New York and other jurisdictions involving disputes among business co-owners, and this is the first I’ve encountered a derivative right to defend for any form of closely held business entity.
An LLC, like any other entity, has the right or even duty to defend itself against litigation claims. The derivative defense issue arose in Horowitz because: (1) Member #2, as one of two 50% members in a member-managed LLC, lacked authority on his own to retain and pay counsel to defend Montauk’s lawsuit in the name and right of the Restaurant, (2) the Restaurant is in receivership, and (3) according to the District Court’s decision in the case, the receiver “failed to act” not based on his business judgment as to the merits of the suit, but only after Member #2 “commit[ted] to defend [the Restaurant] at his own cost.”
With the receiver’s apparent blessing, Member #2, in his own name and by his own counsel, filed a motion in District Court to dismiss Montauk’s suit against the Restaurant. Montauk opposed the motion, arguing that Member #2 lacked standing to litigate derivatively in defense of the Restaurant and that the court should enter a default judgment against it for non-appearance by authorized counsel. The District Court disagreed, holding that Member #2 had standing to defend the suit against Montauk and dismissing the suit without prejudice on procedural grounds.
The Arguments on Appeal
In its subsequent appeal to the Second Circuit Court of Appeals, Montauk’s brief argued that, as opposed to a suit asserting derivative claims on the entity’s behalf, there is “no authority” for the proposition Member #2 “could appear derivatively on behalf of a defendant”; that Member #2 was a “stranger to [the] case and his submissions should not have been considered” by the District Court; that a default judgment against the Restaurant should have been granted; and that even assuming there is no categorical bar to Member #2’s derivative standing, he could not appear derivatively without first establishing that the receiver failed to defend the action due to negligence, fraud, or bad faith.
Member #2’s appellate brief countered that the rationale supporting the common-law right of an LLC member to assert derivative claims on the LLC’s behalf, recognized by the New York Court of Appeals in Tzolis v Wolff, “applies equally to derivative defense of litigation.” The brief cited in support two U.S. Supreme Court cases from 1864 and 1945, and two New York state court decisions from 1899 and 1921, in which courts apparently allowed stockholders to “intervene” or “come in and defend in behalf of the company.” According to Montauk’s reply brief, those cases “make clear that [Member #2] could only [defend the litigation derivatively] upon a showing of fraud or other bad faith on the part of the company management (here, the Receiver).”
The Second Circuit’s Opinion
Circuit Judge John M. Walker, Jr.’s opinion for the unanimous court began his analysis with the statement that “[u]nder New York law, a shareholder has no general right to litigate on behalf of a corporation” but that, under section 626 of the New York Business Corporation Law, “[u]nder certain conditions, . . . a shareholder may litigate to vindicate corporate rights.” The opinion then explains the “conditions” as follows:
The principal condition is that the putative derivative litigant attempt to get the corporate board to act or, alternatively, explain why such an attempt should be excused. The same principle applies when a receiver is in charge. O’Brien v King, 17 NYS2d 44, 45 (1st Dep’t 1940) (where a corporation is run by a receiver, such pre-suit demand must be made on that receiver, which “stands in the place of the managing body”). The demand component stems from the requirement that a derivative litigant demonstrate “a sufficient excuse” as to why it should be allowed to overcome the board’s business judgment and represent the interests of the corporation. See Tzolis v Wolff, 10 NY3d 100, 108 (2008) (quoting Robinson v Smith, 3 Paige Ch. 222, 232–33 (NY Ch. 1832)). This is because, at its core, the issue is whether the litigation decision of the governing board represents the interests of the shareholders. See Auerbach v. Bennett, 47 NY2d 619, 628 (1979). The “real question is one of proper representation.” Id. The New York Court of Appeals has also made clear that these rules as to derivative rights apply with equal force to LLCs and their members. See Tzolis, 10 NY3d at 103.
The opinion’s next paragraph restated the dispositive question as “whether these derivative representation rules allow [Member #2] to represent [the Restaurant’s] interests in defense against the instant suit.” In answering the question affirmatively, thereby rejecting that part of Montauk’s appeal, the court did not give separate answers to Montauk’s two-pronged argument. That is, it did not address as an independent question whether the derivative standing of an LLC member ever can extend to litigation defense.
Rather, the court appears to have assumed such standing in focusing on the second prong, i.e., whether such derivative representation requires a showing that negligence, fraud, or bad faith motivated the managing body’s decision not to litigate. In dismissing Montauk’s position on that question, Judge Walker wrote that the managing body’s malfeasance is not a necessary precondition, and that “New York law looks to a board’s malfeasance only to the extent it may provide a reason to reject the board’s chosen litigation strategy in favor of a different one proposed by a shareholder.”
To this observer, the Second Circuit’s opinion, whatever the force of its rationale for recognizing Member #2’s standing to defend the litigation on Restaurant’s behalf, does not offer a very satisfying explanation. It did not explain its reliance on Business Corporation Law § 626, which only authorizes derivative claims by shareholders. It did not cite a single case authority, from any century or jurisdiction, in which a court upheld a derivative right to defend on the part of a non-controlling shareholder, limited partner, or LLC member. The cases it did cite involved derivative claims, not defenses.
This is not to suggest the court got it wrong under the unique circumstances of the case in which the receiver represented to the District Court that he would have defended the lawsuit but for Member #2’s willingness to do so at no expense to the Restaurant or, indirectly, to its owners including Member #1. Even if a receiver was not on the scene, one certainly can question the equities of allowing one 50% owner to sue his or her own company and then insist a default judgment be entered against it when the same owner prevents it from engaging counsel to put in a defense.
Finally, not all news in the Second Circuit’s opinion was bad for Member #1 who came away with a partial victory by convincing the panel that the District Court erroneously dismissed Montauk’s trademark infringement action.
“We will fight on the beaches,” said Winston Churchill at the start of World War II, and so too, likely for years to come, will the owners of The Sloppy Tuna.