Forced to Buy Out Law Partner’s Interest In Defunct Firm, Years After Withdrawing? It Can Happen
March 09, 2020
Article 12 of New York’s Limited Liability Company Law authorizes the formation of professional service limited liability companies (PLLC). Eligible professions include lawyers, medical doctors, accountants, architects, and various other licensed occupations. Article 12 merely regulates the formation and the professional membership of PLLCs. Otherwise, PLLCs are governed by the same provisions of New York’s LLC Law applicable to non-professional LLCs.
I’m unfamiliar with the organizational or tax-related advantages or disadvantages, if any, peculiar to law firm PLLCs compared to the ubiquitous limited liability partnerships and professional corporations. What I can say is that, since 1994 when New York enacted its LLC Law, I’ve come across relatively few New York law firms organized as PLLCs. Nor have I seen, much less written about, any business divorce cases involving law firm PLLCs, which means either they’re out there operating flawlessly or, as I suspect, they’re few in number.
There’s always a first. Last month, Albany County Commercial Division Justice Richard M. Platkin decided Flink v Smith, 2020 NY Slip Op 50305(U) [Sup Ct Albany County Feb. 7, 2020], involving a dispute between former law partners following the collapse of their PLLC known as Flink Smith Law (FSL).
Justice Platkin’s decision, granting in part and denying in part the defendants’ pre-answer motion to dismiss the complaint, addressed interesting issues concerning the effect of the defendant members’ withdrawal from the PLLC on their undertakings in FSL’s operating agreement to buy out the plaintiff’s membership interest. It also addresses the plaintiff’s claims that his former partners conspired to unlawfully collapse FSL and divert its business to a newly created law firm.
Background
Plaintiff Edward Flink and defendant Jay Smith formed FSL in 1999. In 2010, Flink, Smith, defendant Jennifer Dominelli, and nonparty Robert Coughlin entered into an operating agreement establishing procedures for FSL’s operations, billing requirements, and member compensation. In anticipation of Flink’s retirement in 2018, it also established a process for gradually transitioning ownership and leadership of the firm from Flink as majority owner to the other three.
The operating agreement granted 75 of its 100 “shares” to Flink and the remaining 25 to Smith, with Dominelli and Coughlin initially as non-member contract partners. In 2012, per the agreement, Flink sold 7.5 shares to each of Dominelli and Coughlin. The agreement also contemplated that Flink would sell an additional 2.5 shares to each of Dominelli and Coughlin by the time of Flink’s anticipated retirement date on April 30, 2018, and in the interim any new members would be given the opportunity to buy 4 shares from Flink leaving him with 51 shares.
As to the balance of Flink’s shares, the operating agreement provided for their sale to the other members by April 30, 2018, with the following caveat that became the focus of the eventual litigation:
The LLC will purchase any remaining shares from Ed [Flink] on or before 12/31/18 in the event that the other members do not themselves purchase all of the 51 shares, with the further understanding and agreement that Jay [Smith] and Jenn [Dominelli] will purchase such shares as remain in the event that the LLC is no longer an operating entity and the other members do not elect to purchase the shares.
The operating agreement authorized any member of FSL to “withdraw, resign or retire” from the firm upon three-months notice, with the departing member entitled to certain compensation and the fair market value of his or her shares as of the withdrawal date. The agreement by its terms was to expire on April 30, 2018, unless extended or modified, “except that all obligations which by their nature cannot be performed by that date will continue.”
FSL’s Demise
In December 2016, i.e., less than year and a half before Flink’s anticipated retirement, defendants Smith and Dominelli, together with a third lawyer, formed a new law firm (SDG). In February 2017, they gave FSL written notice of their intent to withdraw effective in May 2017, leaving Flink as the sole member, Coughlin having withdrawn some time prior.
According to Flink’s complaint, SDG took over FSL’s office, hired all but one of FSL’s employees, took its clients, marketed itself as “successor of FSL,” and retained FSL’s physical assets and intellectual property.
Also according to the complaint, while not dissolved, FSL became a “non-operating entity” in which Flink still owned 60 shares which Smith and Dominelli allegedly refused to purchase.
Flink’s Lawsuit and the Motion to Dismiss
About two years after FSL ceased operations, Flink and FSL sued Smith, Dominelli and SDG in a multi-count complaint. The suit accuses them of unlawfully collapsing FSL, diverting its business to SDG, taking excessive compensation while at FSL, and refusing to purchase Flink’s shares, all in breach of their contractual and fiduciary obligations to Flink and FSL.
The defendants responded with a motion to dismiss the complaint. Their primary challenge to Flink’s claims rested on the assertion that their membership in FSL, and all of their prior contractual and fiduciary obligations, ceased to exist upon their withdrawal in May 2017.
As to their alleged, wrongful refusal to purchase Flink’s shares, they also argued that the agreement’s express precondition to any such obligation — “that the LLC is no longer an operating entity” — was not satisfied because FSL had not been dissolved.
They further argued that, insofar as the complaint alleged breach of the operating agreement’s non-compete clause, it failed to allege any facts indicating that, prior to their withdrawal, Smith and Dominelli did anything more than form SDG and, on the contrary, affirmatively alleged that their hiring of FSL employees, false marketing of SDG, etc., began after their departure from FSL.
Flink’s Contract and Accounting Claims Survive
Justice Platkin devoted the bulk of the decision’s analysis to Flink’s breach of contract claim, ultimately concluding that, notwithstanding Smith’s and Dominelli’s withdrawal from FSL as of right in 2017, the complaint states a valid claim to enforce their obligation to purchase Flink’s shares upon FSL ceasing operations following their withdrawal. On the other hand, the decision rejected Flink’s contract claim based on alleged breach of the operating agreement’s non-compete clause.
First, citing LLC Law § 701 (b), Justice Platkin determined that:
the mere withdrawal of Smith and Dominelli did not operate to dissolve FSL or deprive it of the status of an operating entity. As a matter of law and contract, FSL “continued without dissolution” following Smith and Dominelli’s withdrawal, regardless of the fact that Flink was left “as the only remaining FSL member.”
Second, while acknowledging that FSL’s operating agreement does not define “operating entity,” Justice Platkin concluded “there is nothing in the text of the 2010 Agreement to support defendants’ contention that the term is limited to circumstances where the company is ‘incapable’ of operating.” He continued:
Plaintiffs’ Complaint, which is verified by Flink, alleges that FSL ceased operations in or about May 2017, following the withdrawal of Smith and Dominelli, the departure of all but one of the firm’s employees, the loss of the firm’s office space and SDG’s acquisition of FSL’s remaining physical assets and intellectual property. According to the Complaint, FSL “remains a non-operating entity” to this day. As defendants have not submitted documentary evidence to conclusively disprove the foregoing factual allegations, the Court must assume their truth.
Third, and for me the most interesting part of the analysis, Justice Platkin determined that “defendants have failed to conclusively establish that Smith and Dominelli’s withdrawal from FSL relieved them of their alleged duty to purchase Flink’s remaining shares ‘in the event that the LLC is no longer an operating entity and the other members do not elect to purchase the shares.’” As Justice Platkin explained:
Smith and Dominelli’s withdrawal from the firm in May 2017 deprived them of the status of members, but it does not follow that they “lacked any power [to] perform under the operating agreement.” There certainly may be duties in an LLC operating agreement that are capable of being performed only by present members, but defendants have not provided any authority to support their contention that “Smith and Dominelli must be members of FSL” for them “to be obligated to purchase Flink’s remaining shares”. As admitted attorneys, Smith and Domenelli meet the only legal prerequisite to the purchase of Flink’s shares.
Nor have defendants identified any legal impediment to the adoption of an LLC operating agreement that imposes continuing duties on former members, particularly where the duties relate to the purchase of shares as part of a comprehensive buy-out arrangement. While neither side has identified any relevant precedent concerning such a purchase obligation, the Court takes notice of the fact that LLC operating agreements often include provisions intended to be binding on former members, including covenants against competition and confidentiality provisions. . . .
Further, there is nothing in the text of the 2010 Agreement that relieved Smith and Dominelli of the purchase obligation in the event of withdrawal. The absence of such language is notable, given the references in the 2010 Agreement to those “who remain members” and “remaining present members” in connection with the second step of the buy-out process, during which Flink was to sell his shares to the other FSL members on a consensual basis until April 30, 2018. . . .
Viewed in this light, it is difficult to understand Smith and Dominelli’s promise as anything other than a form of financial security for Flink — an assurance that all of his shares in FSL would be purchased by the end of 2018, whether by the members of FSL, the company itself, or, as a last resort, Smith and Dominelli. And if this was, in fact, the objective of the contracting parties, it is not reasonable to believe that Smith and Dominelli could avoid the obligation by the mere expedient of withdrawing from FSL prior to April 30, 2018. [Citations and footnote omitted]
Justice Platkin also also denied dismissal of Flink’s claim seeking an accounting of FSL escrow accounts allegedly opened and controlled solely by Smith and Dominelli, writing:
While Smith and Dominelli no longer have signatory authority over, or online access to, FSL’s accounts, they are alleged to have had access to the accounts at relevant times, and there has been no conclusive demonstration that they do not possess documents or other relevant information concerning receipts and disbursements therefrom.
Flink’s Remaining Claims Do Not Survive
Flink’s complaint also included claims for breach of fiduciary duty, aiding and abetting breach of fiduciary duty (against SDG), and tortious interference with contract (against SDG), each of which Justice Platkin dismissed.
The only claim meriting further comment here is the one for breach of fiduciary duty based on Smith and Dominelli’s alleged misconduct by “secretly forming a competing entity for the purposes of soliciting Flink’s clients and diverting Flink’s business opportunities and good will” and by retaining FSL’s tangible and intangible assets, hiring of FSL employees, etc.
Citing the Court of Appeals’ 1995 landmark Graubard decision, Justice Platkin concluded that defendants’ “mere formation of a competing business entity does not constitute a breach of fiduciary duty, and there are no allegations in the Complaint that defendants made “improper use of [FSL’s] time, facilities or proprietary secrets in [forming SDG].” Justice Platkin also cited the plaintiffs’ “failure to clearly articulate whether they are alleging that Smith and Dominelli engaged in wrongful conduct before their withdrawal from FSL became effective.”
An Unusual Agreement?
At its heart, Justice Platkin’s decision concerning defendants’ buyout obligation is a straightforward matter of contractual interpretation. Viewed thusly, likely it wouldn’t make a difference to the outcome whether the same buyout provisions in the FSL agreement were lodged in the agreement of a law firm organized as a limited liability partnership or professional corporation.
As I see it, where FSL’s organization as a PLLC makes the case somewhat more interesting is the interplay between the operating agreement’s withdrawal rights and the buyout obligations. LLC Law § 606’s default rule prohibits member withdrawal prior to dissolution and winding up unless otherwise provided in the operating agreement. Rules of professional ethics governing lawyers, among other more practical reasons, required FSL’s operating agreement to provide a right of withdrawal.
Case law makes clear that a withdrawn member has no ongoing membership rights or duties but, as Justice Platkin’s decision highlights, nothing prevents parties contractually from taking on post-withdrawal obligations. Did it make sense, economically or otherwise, for the parties in FSL to enter into an operating agreement in 2010 that provided for an unrestricted withdrawal right at any time alongside a contingent obligation on the part of two specified members to purchase a third specified member’s majority interest eight years later should the firm no longer be an “operating entity”?
Only the parties can answer that question. Ultimately, absent settlement, it will be up to the court to decide whether Smith and Dominelli breached their buyout obligation and whether Flink is entitled to damages which, as best as I can tell from the agreement and his complaint, compute to $600,000 at $10,000 per share.