Federal Courts Wade Into Business Divorce: Recent Decisions of Interest
November 07, 2022
Our federal courts by and large are not hospitable to business divorce litigation. The two mainstays of the federal courts’ limited subject matter jurisdiction — federal question and diversity of citizenship — typically are not present in disputes among co-owners of closely held businesses. That’s because such disputes generally feature only state law claims (e.g., breach of fiduciary duty, breach or enforcement of the owners’ agreement, judicial dissolution, dissenting shareholder appraisal proceedings, common-law business torts) between at least two citizens of the same state.
Diversity of citizenship is even more elusive in cases involving unincorporated entities such as LLCs and partnerships which, when named as parties, take on the citizenship of each of their members or partners. And even when diversity exists, courts in most if not all eleven federal Circuits routinely abstain from hearing judicial dissolution claims under the Burford abstention doctrine.
There nonetheless are the occasional business divorce cases that make it into federal court, among other scenarios, by omitting as defendants persons or entities that are not necessary parties whose inclusion otherwise would destroy diversity jurisdiction, or by including federal claims that can only pursued in federal court (e.g., copyright), or as an adversary proceeding in bankruptcy court.
Following are two recent federal court decisions of interest featuring claims among co-owners of closely-held firms. The first involves a law firm organized as a Florida limited liability partnership, the second a Delaware limited partnership that funds litigation-related financing ventures. Both were decided by judges sitting in the Southern District of New York.
While not strictly speaking involving a business divorce, I’m also throwing in for all you LLC mavens a third decision in an unusual case filed in the Eastern District of New York involving a constitutional claim against the New York Secretary of State after it declined to dissolve an LLC fraudulently filed under the plaintiff’s name.
Disputed Expulsion of Law Firm Partner Raises Jurisdictional Issue
In Roche Cyrulnik Freedman LLP v Cyrulnik, five of the six founding partners in the law firm Roche Cyrulnik Freedman LLP (“RCF”), organized as a Florida limited liability partnership, expelled the sixth partner, Jason Cyrulnik, pursuant to a provision in the partners’ memorandum of understanding (“MOU”) authorizing the removal of a partner for cause upon the affirmative vote of 2/3 of the firm’s partners.
Cyrulnik, claiming that his removal was pretextual and that there were no grounds to remove him for cause, demanded that his partners retract the notice of removal. Shortly afterward, the law firm filed a diversity action against Cyrulnik in the Southern District of New York alleging a single claim for a declaratory judgment as to the propriety of Cyrulnik’s removal and limiting his entitlement to the amount provided in the MOU. A little over a week later, Cyrulnik filed suit against RCF and its partners in a Florida court seeking judicial dissolution and asserting various claims for buyout and damages.
Cyrulnik moved to dismiss the S.D.N.Y. action on the ground that diversity jurisdiction was absent because of his own, continuing status as a partner of the firm. RCF countered that the District Court had complete diversity jurisdiction because Cyrulnik no longer was a member of the firm and none of its remaining partners shared a domicile with Cyrulnik.
District Judge John G. Koeltl agreed with neither side, instead applying what he called the “intertwining” rule where resolving jurisdiction is dependent on the resolution of the merits and dismissal is available only where no triable issues of fact exist. Here’s what he wrote:
The determination of RCF’s citizenship . . . cannot be separated from RCF’s claim that Cyrulnik was properly dissociated from the Firm. If RCF is correct on the merits of its claim for declaratory relief, diversity jurisdiction lies: RCF’s citizenship would not be dependent on Cyrulnik’s citizenship because Cyrulnik was removed from the Firm as of February 10, 2021, before this lawsuit was filed, and the parties would be completely diverse. However, if Cyrulnik is correct on the merits of his claim that he was not properly removed from the Firm, diversity jurisdiction is destroyed: Cyrulnik’s status as a partner of RCF would render RCF a citizen of his home state, precluding complete diversity. In short, the “ultimate jurisdictional issue” is “precisely the same as the ultimate issue on the merits.” . . . .
Given the intertwined nature of the jurisdictional question with the merits, “[t]he Court is satisfied that the appropriate way to proceed is to hear and decide the factual issues bearing on its subject matter jurisdiction, recognizing that they also implicate elements of at least one of the substantive claims.” Cyrulnik’s motion to dismiss for lack of subject matter jurisdiction is accordingly denied. [Citations omitted.]
Cyrulnik further argued that, even if the District Court has jurisdiction, it nonetheless should abstain from hearing the case in favor of the Florida action based on three different abstention doctrines including the above-mentioned Burford abstention doctrine. Judge Koeltl examined each of the abstention doctrines and concluded that none applied under the circumstances.
Court Upholds Amendment of Limited Partnership Agreement’s Dissolution Date
In Steven Mizel Roth IRA v Unified Capital Partners 3 LLC, District Judge Naomi Reice Buchwald describes the subject Delaware limited partnership as “an entity that was formed to pool investments into a fund (the “Fund”) for litigation-related financing ventures.” The plaintiff limited partner brought a derivative action against the general partner and the asset manager asserting claims arising from defendants’ alleged failure to dissolve the Partnership by the deadline set forth in the Partnership Agreement.
The Partnership Agreement went into effect on October 1, 2013 and was scheduled to dissolve within three years, provided that the general partner could in its sole discretion extend the term for up to two consecutive one-year periods, i.e., through October 1, 2018.
The general partner effectuated the two extensions. After their expiration, in early 2019, the plaintiff questioned the general partner about the wind-down of the Partnership and subsequently demanded the immediate dissolution of the partnership and distribution of the Fund’s assets. In August 2019, the general partner sent to all 33 limited partners an email informing them of the general partner’s intention to extend the term of the Fund “until 2021.” The limited partners also were sent a voting form regarding the proposed amendment to the Partnership’s term. The plaintiff apparently was the sole objector.
The plaintiff filed suit in November 2019, alleging the invalidity of the amendment extending the dissolution date beyond October 1, 2018. In an earlier decision in the case, Judge Buchwald denied dismissal of the plaintiff’s breach of contract and accounting claims. She agreed, however, with defendants’ interpretation of the Partnership Agreement giving the general partner the authority to amend the dissolution date upon its tendering a written proposed amendment and the limited partners representing a majority in interest either approving the amendment or failing to raise an objection within 25 business days.
In her recent decision deciding dueling summary judgment motions, Judge Buchwald addressed in turn (1) whether the emailed notice to the limited partners constituted a valid amendment; (2) whether the limited partners received notice of the proposed amendment; and (3) whether a majority in interest of the limited partners approved the amendment or failed to raise a timely objection.
Validity of the Amendment. The plaintiff argued that the amendment was invalid because it was not a “written instrument” as required by the Partnership Agreement, was not signed, and did not specify the duration of the extension. Judge Buchwald rejected each contention, finding that the Partnership Agreement’s definition of written instrument encompassed electronic transmission; that the email’s informal sign-off (“Thank you, Ron & Walter”) constituted a valid signature under the federal E-SIGN Act; and that the email’s statement that the Fund will be extended “until 2021” connoted an outside date of December 31, 2021, and therefore constituted a valid amendment of the Partnership Term.
Validity of the Notice. The plaintiff claimed he never received the August email, raising the issue whether it was sent to any of the limited partners although no other limited partner disclaimed receiving it. Judge Buchwald credited the testimony of the general partner’s managing member that he instructed an employee at his office to send the email to all the limited partners (each of whom was addressed in the email) and that he had no reason to believe she did not do so. She also found that the content of the email sufficiently alerted the limited partners to the extension of the Partnership’s term, adding that “any Limited Partner that opposed such extension reasonably should have known to respond to the message stating its disapproval.”
Approval of the Amendment. Finally, Judge Buchwald also rejected the plaintiff’s contention that the amendment lacked the requisite approval or failure to object by a majority in interest of the limited partners. The Court credited the general partner’s “unrebutted statements” that none of the limited partners other than plaintiff — who held less than a 4% interest — objected to the proposed extension of the Partnership’s term, thus a majority in interest ratified the amendment.
Court Dismisses Constitutional Claim Against NY Secretary of State
In Smith v. New York State Secretary of State, the plaintiff discovered that someone had used her name and credit card without her knowledge or authorization to form and register a new LLC with the Department of State (“DOS”). The articles of organization named the plaintiff as the registered agent for service of process at a New York address not belonging to plaintiff.
The LLC’s articles of organization were filed and signed by a person unknown to plaintiff at a Texas address. The plaintiff informed the DOS that her identity was stolen and requested that it dissolve and inactivate the LLC to avoid further damage to her credit. The DOS advised the plaintiff that it had no statutory authority to do either and suggested she contact the District Attorney.
The plaintiff thereafter filed a class action complaint in the Eastern District of New York against the Secretary of State, alleging violations of her right to due process and freedom of association under the U.S. and New York State Constitutions. The complaint sought damages, a declaratory judgment, and an injunction requiring the DOS to provide “a legal mechanism that affords a hearing and constitutionally adequate process by which to challenge the legality of the formation of fraudulent companies created as the result of identity theft” and to dissolve such companies.
The Secretary moved to dismiss the complaint based on the Eleventh Amendment’s bar against federal court jurisdiction over an action against state officials acting in their official capacity. Plaintiff argued that her complaint fell within the exception to Eleventh Amendment immunity carved out by Ex Parte Young, 209 U.S. 123 (1908), for suits against state officials on the basis of state law. District Judge Pamela K. Chen disagreed, pointing not only to the plaintiff’s claims for violation of federal law but also emphasizing that the DOS lacks “the authority and duty to enforce the statutory scheme of limited liability company formations and dissolutions under New York law” and that LLC Law § 209 “expressly prohibits the Department of State from reviewing limited liability company findings ‘for legal sufficiency,’” i.e., the officials of the department of state “lack the power and duty to grant the requested relief.”