Fee Sharing in LLC Derivative Suits: A Common Law Right and a One Way Street
December 07, 2020
BCL 626 governs shareholder derivative actions, or suits brought by individual shareholders on behalf of, and for injury to, the corporation. Subsection (e) provides that if the plaintiff—the individual shareholder asserting the right of the corporation—is successful in recovering anything of value for the corporation, the court in its discretion may award reasonable expenses, including attorney’s fees, to be paid from the award to the corporation.
While BCL 626(e) sets forth the fee-sharing framework in derivative actions brought in the name of a corporation, and New York’s Revised Limited Partnership Law section 121-1002(e) mirrors the BCL and applies to partnerships, there is no corresponding fee-sharing statute for derivative suits commenced and litigated on behalf of other entities, such as LLCs. Without a statutory analogue, is the same fee-sharing framework available?
I have not yet seen a case squarely addressing the issue, but the First Department’s recent decision in Bd. of Managers of 28 Cliff St. Condominium v Maguire, 2020 NY Slip Op 06844 [1st Dept Nov. 19, 2020] may open the door for a successful LLC-member derivative plaintiff to argue that the common law includes the right to recover fees from any award rendered in favor of the LLC.
Although 28 Cliff St. is not itself a dissolution or business divorce case, a dissolution petition often includes a derivative claim against the other owner alleging misappropriation of company assets or business opportunities. Derivative suits have long been a critical instrument in the business divorce practitioner’s toolbox, and fee recovery is a topic close to the hearts of lawyers and clients alike, so we welcome First Department guidance on the issue.
Fee Sharing for the Successful Derivative Plaintiff Under the BCL
BCL 626(e) provides, in relevant part:
If the action on behalf of the corporation was successful, in whole or in part, or if anything was received by the plaintiff or plaintiffs or a claimant or claimants as the result of a judgment, compromise or settlement of an action or claim, the court may award the plaintiff or plaintiffs, claimant or claimants, reasonable expenses, including reasonable attorney’s fees, and shall direct him or them to account to the corporation for the remainder of the proceeds so received by him or them.
Good policy underlies the fee-sharing framework set forth in 626(e). Because a successful derivative suit confers on the corporation a benefit for which the corporation itself would otherwise have had to pay, section 626(e) allows the court to award plaintiffs attorney’s fees incurred in securing that benefit. The prospect of fee recovery also makes derivative suits more economically feasible, furthering the derivative suit’s important role as a layer of corporate accountability.
Notably, 626(e) does not, as some fee-shifting statutes do, increase the amount due from the wrongdoer. Nor does it allow for a prevailing defendant in a derivative suit to seek fees against the corporation. Rather, BCL 722 and 724 provide the statutory framework for advancement and indemnification of a corporate director or officer.
The Pub Fire at 28 Cliff St.
While Leopold Bloom mused (in the famously not obscene Ulysses) that a “good puzzle would be to cross Dublin without passing a pub,” crossing Manhattan in such an abstentious route might be an even greater challenge. As an unintended consequence of New York City’s glut of ale houses, the pages of this New York Business Divorce blog have featured scores of posts covering dissolutions, buyouts, valuations of, or misconduct at all manner of pubs, bars, lounges, and nightclubs. 28 Cliff St. is another.
The 28 Cliff St. Condominium is a four-unit, unincorporated condominium in downtown Manhattan. Defendant Philomena Maguire is the former president of the condominium board and a proprietor of Ryan Maguire’s Bar & Restaurant, which occupies the ground floor commercial space in the building.
In 2010, a fire started in the cellar of the pub, causing extensive damage to the entire building and displacing the residents for more than a year. The condominium filed a claim under its general insurance policy, and the insurer ultimately paid more than $1.2 million for damages caused by the fire. As then-president of the board, Maguire coordinated the restoration of the building and, consequently, the disposition of the $1.2 million in insurance proceeds.
Four years later, in 2014, the unit owners sued Maguire and the other owners of the pub, alleging that they had misappropriated the insurance proceeds by using the funds to improve and expand the pub while skimping on repairs to the remainder of the building. The unit owners’ original complaint contained a slew of derivative and direct claims, but the trial court quickly dismissed the derivative claims, in part because the derivative and direct claims were so intertwined that it was impossible to tell one from the other.
Maguire sought indemnification from the condominium for her defense against the dismissed derivative claims and remaining direct claims. Maguire argued that the condominium claims were subject to New York’s Real Property Law, and because the RPL was silent on the issue of indemnification, BCL 722 and 724, which allow for indemnification, applied to fill in the gaps left by the RPL.
The Lower Court Applies the BCL
The trial court found that in the absence of an applicable provision in the RPL, the BCL applied to the derivative suit brought in the name of the unincorporated condominium. It relied on language in First Department’s decision in Tsui v Chou, 135 AD3d 597 [1st Dept 2016], which cited BCL 626(e) in support of its holding that in the condominium context, successful derivative plaintiffs may pursue their claims for fees against the condominium.
So, because the trial court read Tsui to apply BCL 626(e) in the unincorporated condominium context, the trial court concluded that the BCL’s provisions on indemnification—BCL 722, 724—must also apply. “To rule otherwise,” the trial court reasoned, “would be to accept the nonsensical result that plaintiffs in derivative condominium actions, individual unit owners, may recoup attorney’s fees pursuant to the BCL but defendant officers and directors may not do the same under the same statute.”
The First Department: While the BCL Might be Instructive, Common Law Applies
Recognizing that its prior holding in Tsui was capable of different interpretations, the First Department in 28 Cliff St. took care to make a clearer statement. The Court held that the rights of unit owners in derivative suits on behalf of unincorporated condominium associations are governed by the common law, not the BCL. Tsui merely cited the BCL in its interpretation of the common law:
[W]e clarify that Tsui does not stand for the proposition that where the RPL is silent, the BCL broadly applies to all condominium associations to fill in the gaps. The “see” reference to BCL § 626(e) in Tsui is merely an acknowledgment that the BCL can be looked at for guidance in interpreting the common law on derivative actions.
Turning then to the common law on derivative actions, the Court held that in contrast to BCL 722 and 724, there was no right to indemnification or advancement at common law, so Maguire’s indemnification and advancement claims must fail.
From Condos to LLCs?
28 Cliff St. potentially is significant beyond the condominium context. For one, it reaffirms that the BCL does not apply to derivative suits on behalf of unincorporated entities, such as condominiums and LLCs; the common law does. (See also Matter of 1545 Ocean Avenue, LLC, 72 AD3d 121 [2d Dept 2010][holding that the BCL’s dissolution sections do not apply to LLCs]). Nonetheless, the BCL may be instructive in interpreting that common law.
28 Cliff St. also clarifies that the First Department’s 2016 ruling in Tsui involves application of the common law. According to 28 Cliff St., Tsui—which upheld the right of a successful derivative plaintiff to seek fees—is a common law case. This means that under the common law, a successful plaintiff in a derivative suit may be awarded fees from the entity on whose behalf the suit was prosecuted.
In Tzolis v. Wolff, 10 NY3d 100 , the New York Court of Appeals held that the common law provides LLC members the right to sue derivatively on behalf of the LLC to recover for wrongs perpetrated against the LLC. It won’t be long before a creative LLC member cites 28 Cliff St. and Tsui in support of the argument that LLC members’ common law derivative rights include the right to seek recovery of fees and expenses incurred while prosecuting the action in the name of the LLC.
Finally, 28 Cliff St. also counsels that under the common law, fee sharing is a one-way street. The common law does not allow for indemnification and advancement of corporate officers who are sued derivatively. So if there are any indemnification or advancement rights to be found by an LLC member or manager sued derivatively, those rights lie in the operating agreement, not the common law. For a more complete summary of the law on indemnification and advancement in the context of LLC disputes, see my colleague Frank McRoberts’ post, Can the Company Pay My Legal Fees?
In sum, in the wild west of LLC derivative lawsuits, 28 Cliff Street offers—albeit indirectly—an additional foothold for a successful plaintiff to assert its right to recover fees from the award in favor of the LLC.
A final, interesting note: 28 Cliff St. confirms that First Department Justice Gische remains an active force in the development of law surrounding LLC members’ rights to bring a derivative action. After Tzolis, Justice Gische was the first to hold, in Evans v. Perl, 19 Misc3d 1119[A] (Sup Ct NY County 2008), that the common law subjected LLC derivative plaintiffs to the same pre-suit demands requirements as the BCL requires of shareholder derivative plaintiffs. Justice Gische then sat on the panel in Tsui and authored 28 Cliff St.