Enforceability of Oral Operating, Shareholder, and Partnership Agreements
August 24, 2020
Oral agreements – and oral modifications of written agreements – are a constant source of litigation in business divorce cases. Alleged oral agreements are subject to attack based upon legal enforceability – as well as their ability to be proven with adequate evidence. As a general matter, legal enforceability of an alleged oral agreement among business owners concerning their rights as owners depends first and foremost upon the kind of entity involved.
Limited Liability Companies
Section 102 (u) of the Limited Liability Company Law (the “LLC Law”) defines the term “operating agreement” as a “written agreement of the members.” LLC Law § 417 (a) provides that the LLC’s members “shall adopt a written operating agreement.” As we noted previously, the wording of the LLC Law differs markedly from Delaware’s LLC Act and that of many other states, which explicitly permit oral operating agreements.
Based upon the language of the LLC Law, the prevailing view in New York is that oral operating agreements are unenforceable. For example, in Shapiro v Ettinson, 146 AD3d 650 [1st Dept 2017], the court held that an alleged oral agreement requiring member unanimity to adopt an operating agreement was unenforceable because LLC Law § 417 “requires a written operating agreement, and where there is no operating agreement or the operating agreement fails to address issues in dispute, the default provisions under the Limited Liability Company Law govern.”
However, there is a line of authority, emanating largely from decisions of the Appellate Division – Second Department, creating some room for litigation of alleged oral agreements among LLC members where the written operating agreement does not address a particular subject matter. For example, in Gerard v Cahill, 66 AD3d 957 [2d Dept 2009], the court allowed a claim for an alleged oral buyout agreement to survive a motion for summary judgment, ruling that the “oral agreement was a separate, additional agreement addressing a scenario that was not anticipated and not covered by the terms of the operating agreement.”
A fair share of the articles we write on this blog involve disputes over whether one is a shareholder of a corporation – often based upon alleged oral agreements. Oral stock sale or transfer agreements used to be unenforceable under Section 8-319 of the Uniform Commercial Code (the “UCC”). Based upon this statute, in Kingston v Breslin, 25 AD3d 657 [2d Dept 2006], the court held that an “alleged oral agreement between the plaintiff and the defendant . . . that the plaintiff was a 15% shareholder . . . is not enforceable, since it violated UCC § 8-319, the securities statute of frauds, which was in effect at all relevant times.”
Although UCC § 8-319 was repealed effective October 10, 1997, the statute continues to apply to alleged oral stock transactions prior to that date (see e.g. Guarino v N. Country Mortg. Banking Corp., 79 AD3d 805 [2d Dept 2010]). The current state of the law is the opposite – under UCC § 8-113, “a contract or modification of a contract for the sale or purchase of a security is enforceable whether or not there is a writing signed” to memorialize the transaction. In Hill v Fuld 360 Inc., 2019 NY Slip Op 30718[U] [Sup Ct, NY County 2019], the court ruled that an alleged oral employment agreement in which plaintiff-employee would have been entitled to a 5% equity stake in a corporation “constitutes a contract for the sale or purchase of a security” and “pursuant to UCC § 8–113, it is enforceable whether or not it is in writing.”
There are some important limits, though, on potential enforceability of oral shareholder agreements. One of New York’s statutes of frauds, Section 5-703 (1) of the General Obligations Law (the “GOL”), prohibits oral agreements for the purchase of an “estate or interest in real property.” In a line of appellate cases that includes Wells v Hodgkins, 150 AD3d 1449 [3d Dept 2017], courts have applied the statute of frauds prohibiting oral agreements for purchase of real property to include purchases of “shares of stock in a corporation whose only asset was an interest in real property.”
Of all New York business entities, general partnerships have the most liberal rules governing oral agreements. “The law is well settled that a partnership agreement may be oral” (Missan v Schoenfeld, 95 AD2d 198 [1st Dept 1983]). One court went so far as to state, “An oral partnership agreement is valid even where a written agreement is contemplated, and a failure to establish that the oral agreement left open for future agreement any essential terms not implied by law weighs in favor of the existence of a partnership by oral agreement” (Keen v Jason, 19 Misc 2d 538 [Sup Ct, Suffolk County 1959], affd 11 AD2d 1039 [2d Dept 1960]). “When there is no written partnership agreement between the parties, the court must determine whether a partnership in fact existed from the conduct, intention, and relationship between the parties” under the usual rules for partnership formation found in Sections 10 and 11 of the Partnership Law (Community Capital Bank v Fischer & Yanowitz, 47 AD3d 667 [2d Dept 2008]).
The main restriction on oral partnership agreements is the statute of frauds. One statute of frauds commonly applied to partnerships: oral agreements that cannot be performed within one year, which are prohibited under GOL § 5-701 (a) (1). One way to avoid the statute’s application? Allege an oral agreement for an indefinite term. “An oral agreement to form a partnership for an indefinite period creates a partnership at will and is not barred by the Statute of Frauds” (Prince v O’Brien, 234 AD2d 12 [1st Dept 1996]).
The rules for oral partnership agreements are so liberal that oral agreements for partnerships whose sole asset is real property generally do not fall within the statute of frauds, even though similar arrangements for corporation do. In Liffton v DiBlasi, 170 AD2d 994 [4th Dept 1991], the court held, “The Statute of Frauds is not applicable to an oral partnership agreement to deal in real property because the interest of each partner in a partnership is deemed personalty.” Shares of stock are generally considered personal property as well. Why should there be a variance in enforceability of oral agreements between corporations and partnerships whose sole asset is real property?
What about limited partnerships? Earlier this month, a New York appeals court considered for the first time the correct interpretation of what one could characterize as a built-in statute of frauds applicable to amendment of limited partnership agreements in Partnership Law § 121-110.
The statute applies to limited partnership formed on or after July 1, 1991, and those formed earlier who elected to adopt the Revised Limited Partnership Act. Similar to LLC Law § 417 (a), Partnership Law § 121-110 (a) provides that a limited partnership “shall have a written partnership agreement.”
Partnership Law § 121-110 (c) further provides that although the agreement “may be amended from time to time,” six categories of transactions are unenforceable “without the written consent of each partner adversely affected thereby.” These categories include:
- increasing the obligation of a limited partner to make contributions,
- altering the allocation of any item of income, gain, loss, deduction or credit for tax purposes,
- altering the manner of computing distributions of any partner,
- altering the voting or other rights of a limited partner,
- allowing the obligation of a partner to make a contribution to be compromised by consent of fewer than all partners, and
- altering the procedures for amendment of the partnership agreement.
In A&F Hamilton Hgts. Cluster, Inc. v Urban Green Mgt., Inc., 2020 NY Slip Op 04440 [1st Dept Aug. 6, 2020], the parties executed a limited partnership agreement (the “LP Agreement”). Five years later, as part of a real estate refinancing, an attorney drafted, but the parties never signed, an amended limited partnership agreement (the “Disputed Amendment”). The Disputed Amendment would have radically altered the partnership, in effect boosting the 1% limited partner to a 99% general partner. The appellate panel in A&F reviewed what the court described as a “well-reasoned opinion” by Manhattan Commercial Division Justice O. Peter Sherwood granting summary judgment declaring the Disputed Amendment unenforceable, and a subsequent order dismissing most of the limited partner’s Second Amended Complaint.
The appeals court held:
The unsigned amendment purports to alter the allocation of distributions and tax losses to the partners. The 1999 agreement contains no provision that would allow for such changes without a writing memorializing the consent of the adversely affected partners. Therefore, the default requirement of an executed writing applies, as provided in [Partnership Law] § 121-110 (c). It is undisputed that no party has located, much less authenticated, an executed version of the unsigned amendment. As it has not been signed by any adversely affected partner, the unsigned amendment is of no effect.
The court rejected application to limited partnerships of the rule – sometimes applied to general partnerships – that “parties can modify a contract by their conduct.” The court explained:
That is true of course as a general matter. However, the contract in this case is one that is subject to a detailed statutory scheme, and therefore the ‘modification by conduct’ argument requires greater scrutiny. The Fendt faction cites only one case that involved modification of a partnership agreement by conduct (see Estate of Kingston v Kingston Farms Partnership, 130 AD 3d 1464 [4th Dept 2015]). However, that case did not involve a provision, such as [Partnership Law] § 121-110 (c), that requires changes to specified aspects of the limited partnership to be consented to in writing, unless the parties’ agreement provides otherwise.
An Open Question
One interesting question raised by A&F: the extent to which its holding may apply by analogy to LLCs. LLC Law § 417 was modeled on Partnership Law § 121-110. In particular, the language of subsection (b) of the former mirrors subsection (c) of the latter. Based upon the similarity of the two statutes, it seems likely that future litigants opposing an alleged oral modification of a written operating agreement will rely upon A&F to argue unenforceability.
For those interested in taking a closer look at the parties’ arguments in A&F, you can read the appeal briefs here, here, and here.