Disputes Over Member Status Continue to Roil the LLC Waters

July 13, 2020

I don’t know if empirical studies have been done comparing the relative frequency or ratio of disputes and litigation over member status in LLCs versus shareholder status in close corporations. My impression as an avid follower of case law in New York and other states is that LLC disputes over member status win that dubious distinction. If I’m right, the question is, why? Is there something innate about the LLC form that gives rise to a higher incidence of litigation over an individual’s or entity’s ownership stake?

I believe the answer is “yes” at least to some extent based on the peculiar default rules — often mirrored or made even more restrictive in operating agreements — governing the transfer of membership interests. I’ve seen and written about any number of cases in which the membership interest asserted by a transferee comes to naught, or is relegated to an economic interest only, because of a failure to obtain the consent of the members or managers in compliance with requirements in the statute or operating agreement. Other contributing factors, not limited to transferees, may be the relative infrequency compared to corporations with which LLC membership interests are formally certificated, and default rules permitting variable voting and economic percentages based on changes in a member’s capital account.

All of which is by way of introduction to three, recent court decisions by three different New York City judges addressing disputed ownership interests, two involving LLCs and one a close corporation. Two of the three involve family-owned companies, where naturally there tends to be less adherence to formalities, which reminds me of a wonderful quote in a paper by the late, great Larry Ribstein (read here) in which, commenting on the family origins of partnerships, he wrote:

The earliest small firms were partnerships, which began as intimate, usually family, relationships. They were referred to as ‘compagnia,’ which means those sharing bread, reflecting their origins in households. Kinship ties were an important mechanism for controlling agency costs. Kerim told James Bond in From Russia With Love, “all of my key employees are my sons. Blood is the best security in this business.”

To which I can only add, except when it’s not.

Case No. 1: S.O.S. Realty Associates LLC v Blumberg, 2020 NY Slip Op 32200(U) [Sup Ct NY County July 7, 2020] 

The aptly named S.O.S. Realty Associates LLC was formed in 1995 to own and manage a 15-unit Manhattan apartment building, owned 50/50 by Naomi Blumberg and Melvyn Oberlander. In late 1998 or early 1999, according to the complaint, pursuant to a pair of Assignment and Acceptance Agreements, Naomi “attempted” to assign 10% of her membership interest to her son David and another 10% to her daughter Lynda. According to S.O.S.’s complaint, the agreements were signed by Oberlander, Naomi, and Lynda but, “upon information and belief,” David never signed them even though a signature above his signature line appears on the documents.

The governing operating agreement, consistent with LLC Law § 603, provided that an assignment of an interest only entitles the assignee to allocations and distributions, unless admitted as a member. It also required a new member to execute a consent to be bound by the operating agreement. Concurrent with the assignments to David and Lynda, all four parties allegedly signed an amended operating agreement reflecting the assignments.

It was undisputed that S.O.S’s tax returns reported David as a 10% member for the next 20 years. In 2014, upon his request, S.O.S. sent an accounting to him substantiating distributions made to him from 1999 to 2014. Also in 2014, David sued S.O.S. alleging freeze-out from management and depriving him of distributions. The case settled with a $350,000 payment to David.

In 2019, in response to a request to David for photo identification in connection with a mortgage loan sought by S.O.S., David’s counsel wrote to S.O.S.’s counsel that “you should be aware that the Amended SOS [operating] agreement that has my client’s signature is forged.” Allegedly the loan did not close due to David’s counsel’s forgery claim.

S.O.S. then brought suit against David, seeking a declaration that he has no membership interest because he failed to comply with the original operating agreement and that the amended operating agreement erroneously included him as a 10% member. The complaint also sought to recover against David for tortious interference with the S.O.S.’s mortgage loan.

David counterclaimed for declarations as to the validity of his 10% membership interest. He alleged that his signatures on the Assignment Agreements were genuine but not on the amended operating agreement which allegedly was forged and therefore the agreement was invalid. He also asserted counterclaims for judicial dissolution, breach of fiduciary duty, and other causes of action relating to the failed mortgage application, the alleged forgery, and failure to make distributions.

Basically, it boiled down to David claiming that, between the assignments which he did sign and S.O.S.’s documented recognition of him as a 10% member for decades on its tax returns and otherwise, he was entitled to a declaration of his 10% ownership notwithstanding his allegedly forged signature on the amended operating agreement. On the other side, Naomi claimed that the assignments and amended operating agreement were all prepared and signed together so if the amended operating agreement was invalid due to David’s allegedly forged signature, then so too his signatures on the assignments were forged and therefore they too were invalid.

In his decision issued last week (read here), Supreme Court Justice Gerald Lebovits granted summary judgment in David’s favor on his 10% membership interest. Justice Lebovits highlighted Naomi’s admission that she intended to assign a 10% interest to each of her children, that S.O.S. made distributions and issued K-1s to David for 20 years based on his 10% membership interest, and offered no explanation as to whom would have forged David’s signature, why it would have been forged, or why the issue of forgery was not raised long since. He also found that the Assignment Agreements satisfied the requirement for new members to confirm their consent to be bound by the operating agreement.

David did not fare as well on his claim to invalidate the amended operating agreement. Justice Lebovits found that his signature on the document “was very light and difficult to see or compare” and that “he fails to point out any differences or distinctions with that signature and his signature on the Assignment Agreements or any other documents.” The judge also cited issues of fact based on Naomi’s allegation that the Assignment Agreements and the amended operating agreement were all signed simultaneously.

Case No. 2: Jensen v 1050 Pacific, LLC, 2020 NY Slip Op 31170(U) [Sup Ct Kings County Apr. 22, 2020]

This case involves a disputed 5% ownership interest claimed by the plaintiffs in certain commercial realty owned by the defendant LLC based on an agreement made in 2015. Even though the plaintiffs were not claiming any membership interest in the LLC, the LLC’s defense of the claim turned on the alleged membership in the LLC of a certain non-party named Hershel Herbst who in 2012 allegedly entered into an agreement with the LLC referred to as a “Declaration,” stating that he was a member and manager, and that no transfers of the company’s property could be made without his consent.

The LLC’s initial motion to dismiss the complaint was denied by Commercial Division Justice Leon Ruchelsman (read here), finding insufficient evidence Herbst was an owner of the LLC whose Form K-1’s did not list Herbst as an owner. The LLC next moved to reargue the court’s decision, contending that the Declaration also appointed Herbst as “manager,” thus his absence from the K-1’s did not raise any questions of fact whether Herbst’s consent was required.

Justice Ruchelsman denied the reargument motion. His Decision and Order (read here) rejected the LLC’s argument that, “notwithstanding one portion of the Declaration that the court held was insufficient to dismiss the action, a different portion of the same Declaration is sufficient to dismiss the action.” The Declaration, Justice Ruchelsman wrote, “cannot be parsed in that fashion.” The judge also emphasized that the designations of Herbst as both member and manager “are stated in the very same sentence” and that questions of fact as to Herbst’s status as a member likewise raise questions whether Herbst “was the sole managing member as well.”

Case No. 3: Chun You Cheng v Yang, 2020 NY Slip Op 50801(U) [Sup Ct Queens County July 9, 2020]

The opening line in the analysis portion of Commercial Division Justice Leonard Livote’s post-trial opinion last week (read here) says it all:

In this case, the parties invested millions of dollars in the construction of a multi-story building. However, they did so with less paperwork than would accompany the sale of a single family home and a complete disregard of corporate formalities. Thus, the first question before the Court is to determine the scope of the parties’ agreement.

The many players in this case are related by blood or marriage. The undocumented ownership of the subject corporation that owned the land and a major, mixed use construction project, Garden View Ltd. (GVL), and the investors in the project, resemble nothing so much as a game of musical chairs among various members of the extended family.

Justice Livote found that the original three, intended owners contemplated equal one-third ownership interests in GVL but orally agreed that the percentages ultimately would be determined upon the project’s completion based upon the actual amount of capital each person contributed. When one of the three dropped out after a couple of years, the two remaining investors, including the plaintiff, contemplated equal 50% ownership interests but, as with the first oral agreement, the relative interests ultimately would depend on actual capital contributions upon project completion.

The father of one of the two remaining owners subsequently invested about $4.5 million in consideration of a promised, undocumented equity interest. The plaintiff initially objected to adding another equity member but, as Justice Livote found, he acquiesced and, along with the other original investor, executed a memorandum regarding profit sharing stating: “AS PER OUR AGREEMENT, THE PROFIT SHARING FROM GARDEN VIEW LTD., FOR [plaintiff] CHUN YOU CHENG & [defendant] CHIU MING YANG CHENG HAS BEEN CHANGED FROM ORIGINAL 1/2 TO 1/3.”

The construction project — a 14-story residential condominium — was completed in 2004 and unit sales began the following year. Justice Livote’s opinion doesn’t detail what went on between then and 2012 when the plaintiff sued for a declaration of ownership interests in GVL along with derivative claims. Apparently, prior to suit the defendants took the position that the plaintiffs had been bought out of their interest along the way.

Stating that the “crux of the case is who owns what percentage of GVL,” and finding that “there was undoubtedly an intent to be bound,” Justice Livote went on to conclude that GVL had three, one-third owners including the plaintiffs. In so finding, he rejected defendants’ contention that “payments made to plaintiffs were part of a buyout” and, therefore, that the various payments to the parties “shall be treated as constructive dividends” for purposes of trueing-up amounts due the three owners.

Based on actual dividends and other payments made, Justice Livote computed that the defendants were due an additional $3.8 million. He also concluded that his treatment of the payments to the parties as constructive dividends “achieved a substantial benefit to the corporation” in connection with the plaintiffs’ derivative claim for corporate waste and therefore awarded plaintiffs their attorney’s fees in an amount to be determined.