Does This Decision Put the Brakes on Non-Unanimous Amendments to Operating Agreements?
October 08, 2018
Much digital ink has been spilled on this blog (here, here, here, and here) and elsewhere (Tom Rutledge’s terrific article can be read here) concerning the ability of LLC controllers to adopt or amend an operating agreement without the consent of all members.
In New York, Shapiro v Ettenson kicked things off, holding that the majority members of an LLC validly adopted a post-formation operating agreement without the minority member’s consent. The agreement in that case eliminated the minority member’s salary, authorized dilution of a member interest for failing to make mandatory capital contributions (the majority members issued a capital call promptly after the amendment), and member expulsion (the majority members expelled the minority member soon after the court upheld the LLC agreement).
Next came Ho v Yen where the court denied interim injunctive relief to a minority member who challenged the majority members’ adoption of a post-formation LLC agreement that authorized member expulsion and buy-out at book value (the majority members expelled the minority member within days after the amendment).
The appellate panel in Shapiro rested its holding on LLC Law § 402 (c) (3) which speaks to the majority’s right not only to adopt an operating agreement but also to amend it subject, of course, to any contrary provision in the operating agreement and certain statutory carve-outs in LLC Law § 417 (b). But since the vast majority of operating agreements that I’ve seen expressly require the consent of all members to amend, I figured I’d have a long wait before seeing a case that tests the limits of the non-unanimous amendment power.
My wait wasn’t nearly as long as I expected. Last month, in Yu v Guard Hill Estates, LLC, 2018 NY Slip Op 32466(U) [Sup Ct NY County Sept 28, 2018], Manhattan Commercial Division Justice Saliann Scarpulla denied a motion to dismiss a minority LLC member’s claims against the majority members for breaching their fiduciary duty by adopting, without the minority member’s consent, amendments authorizing mandatory capital calls and foreclosing upon the interest of a member who fails to contribute. What makes the case even more interesting is that the pre-existing operating agreement signed by all the members included a provision generally authorizing amendment by vote of members holding 51% of the member interests.
The Yu Family Feud
If the name of the case sounds familiar, that’s because this is the third week in a row this blog has featured decisions by Justice Scarpulla in three separate lawsuits between Patrick Yu on the one side and his parents and two siblings on the other. The family feud apparently started in 2013, when Patrick defied his father’s wishes concerning Patrick’s sale of his own Westchester homestead.
Last August, in the first decision in Case #1 reported here, the court dismissed Patrick’s claims under LLC Law § 702 for judicial dissolution of two family-owned LLCs based on allegations that his siblings’ “retaliatory” and “oppressive” amendments to the operating agreements were inconsistent with the LLCs’ intended estate-planning purposes.
In the second decision in Case #2 also issued last August and reported here, Justice Scarpulla dismissed Patrick’s claim alleging shareholder oppression under Business Corporation Law § 1104-a and seeking judicial dissolution of the family-owned corporation because Patrick had collaterally assigned his shares’ voting rights as part of a pledge agreement securing a loan from the corporation. Justice Scarpulla nonetheless kept alive Patrick’s parallel claim for common-law dissolution.
Justice Scarpulla’s most recent decision in Case #3 involves one of the same LLCs, called Guard Hill Estates, LLC, that was the subject of her August decision in Case #1 dismissing Patrick’s § 702 claims for judicial dissolution. In both cases, Patrick alleged that the amendments to Guard Hill’s operating agreement were part of a retaliatory, bad faith, “personal vendetta” against him by his siblings seeking to deprive him of his ownership interest in the LLC’s real estate asset — the family estate in Bedford, New York. Instead of seeking judicial dissolution as in Case #1, in Case #3 Patrick’s complaint asserted claims against his siblings for declaratory judgments invalidating the amendments and for breach of fiduciary duty, seeking to prevent his siblings from foreclosing on his membership interest and also seeking money damages.
The Siblings’ Motion to Dismiss
Patrick’s siblings moved to dismiss the complaint primarily on the ground that the amendments were properly adopted by majority consent as authorized by the original operating agreement, and therefore as a matter of law could not constitute a breach of fiduciary duty.
In opposition, Patrick argued that his allegations about his siblings’ credibility, motive, and intent adequately pleaded claims for breach of fiduciary duty; that their actions were not taken in “good faith” or in “legitimate furtherance of corporate purposes”; and that their adoption of the amendments and execution of the capital call — knowing that Patrick lacked the financial wherewithal to pay it — was done in furtherance of their agenda to oust him from the family business rather than to benefit the LLC or fulfilling a need in the company.
Justice Scarpulla’s opinion, after stating the basic elements of a cause of action for breach of fiduciary duty, sets forth the guiding legal principles when contractual rights clash with fiduciary duty, and when the former gives way to the latter:
Applying these principles and, as required on a pre-answer motion to dismiss, accepting as true Patrick’s complaint’s factual allegations, Justice Scarpulla held that Patrick’s complaint adequately pleaded claims for breach of fiduciary duty, writing:
I find that Patrick sufficiently alleged facts to support a cause of action for breach of fiduciary duty. Defendants argue that they properly exercised their contractual rights by initiating the capital call and effecting the promissory notes and pledge agreements. Patrick alleges that defendants’ actions were not taken in good faith and in legitimate furtherance of corporate purposes, rather, they were taken as part of a family vendetta to oust him from the family entities. He describes the history and background of the family dispute and describes how the actions taken by his siblings and Guard Hill were in furtherance of the family’s agenda, rather than to fulfill a need in the company. Because of the actions taken, he now owes $590,887 on the promissory notes executed by [defendants] on his behalf, and his shares in Guard Hill are pledged. While [defendants] did have certain rights under the Guard Hill operating agreement, whether they exercised those rights in good faith and in an equitable manner is disputed and must be determined through the course of litigation [italics added].
Where Does Yu, and Where Do We, Go From Here?
Currently, I’d score the Yu family feud as a tie game in the early innings. True, Patrick’s siblings knocked out his LLC dissolution claims in Case #1, but the survival of his fiduciary breach claims in Case #3 means that his effort to invalidate, or prevent enforcement against him of, the amendments to Guard Hill’s operating agreement will forge ahead, subject, of course, to any decision by the siblings to take an interlocutory appeal from Justice Scarpulla’s decision. Patrick’s claim in Case #2 for common-law dissolution of the family’s main operating business also will forge ahead, and could benefit from spillover effect should the court in Case #3 find that the siblings’ actions breached fiduciary duty. One can only hope, for the sake of the family, that the uncertainties on both sides will encourage an out-of-court settlement.
As for the rest of us, Justice Scarpulla’s latest decision is the first indication by a New York court that the fiduciary duties owed by the LLC’s controlling managers, under the right factual circumstances, may act as a brake on their ability to amend the operating agreement to add provisions for member expulsion, mandatory capital calls, and the like that appear facially neutral but are designed to be wielded against a dissident minority member whose consent to the amendment was neither sought nor obtained.
Finally, if fiduciary duty constrains the amendment power in cases such as Yu, where the original operating agreement signed by all members expressly authorized amendment by majority vote, logically it also should constrain amendment under LLC Law § 402 (c) (3) in those presumably rare instances where the LLC’s operating agreement is silent on the subject of amendment.