Gymnastics Business Falls Off the Beam in LLC Dissolution Case
August 27, 2018
Very few and very far between are cases in which the holder of a minority membership interest in a New York LLC — with or without a written operating agreement — prevails in an action brought under section 702 of the New York LLC Law for judicial dissolution. Mainly that’s because the statute’s “not reasonably practicable” standard as interpreted by the courts is limited to a showing of the LLC’s failed purpose or financial failure, and thus excludes as grounds for dissolution oppression, fraud, or other overreaching conduct by the majority directed at the minority.
Last week, in one of the rare exceptions to the general rule, Nassau County Commercial Division Justice Timothy S. Driscoll handed down a post-trial decision granting the judicial dissolution petition of two individuals holding a collective 42% membership interest in an LLC that operates a gymnastic facility. In Matter of D’Errico (Epic Gymnastics, LLC), Decision & Order, Index No. 610084/2016 [Sup Ct Nassau County Aug. 21, 2018], Justice Driscoll held that dissolution under section 702 was warranted where, after dissension arose, the majority members formed a new, similarly named entity to collect the subject LLC’s revenues and to dole them out to the subject LLC if, as, and when the majority members saw fit, thereby reducing the subject LLC to a “marionette to be manipulated at will by [the new LLC].”
The decision deserves attention, not only in respect of its navigation of the prevailing dissolution standard articulated by the Appellate Division, Second Department, in the 1545 Ocean Avenue case, but also as a cautionary lesson for business divorce counsel about the potential backfire of overly aggressive self-help measures undertaken by controllers in response to perceived acts of disloyalty or abandonment by minority members.
In 2014, petitioners Nicole and Louis D’Errico, collectively holding 42% membership interests, and respondents Anthony Bruno, Michelle and Rigoberto Camacho, collectively holding 58% membership interests, formed Epic Gymnastics, LLC to operate a high quality gymnastics facility at a leased facility in Freeport, New York. The members had no written operating agreement.
Anthony contributed over $300,000 for the build-out. The D’Erricos contributed their labors during construction and took on office and business management responsibilities. Nicole D’Errico also personally guaranteed Epic’s credit card and used her personal credit card for purchases during the build-out and after the facility opened in 2015.
Tensions arose between the petitioners and respondents as the business failed to reach profitability over the following two years. In mid-2016, claiming that petitioners had voluntarily left the business to start a competing gymnastics program, the respondents cut off Nicole’s access to Epic’s online banking and allegedly locked out physically both petitioners from the business premises and from accounts that Nicole used to run Epic’s operations. The parties also ceased speaking with one another. At the time of the lock-out, Epic owed approximately $20,000 on its credit card guaranteed by Nicole — by the time of trial, the number grew to $38,000 — and Nicole incurred $22,000 in unreimbursed personal credit card debt for purchases she made for the company.
The D’Erricos filed a petition for judicial dissolution in December 2016. Subsequently, together with a third person not involved in the case, the respondents formed an entity known as “BeyondEpic” which they used to collect all of the payments from what had been Epic’s gymnastic students. Students and teachers used the same location which operated under the same “Epic” signage. No written agreement existed between Epic and BeyondEpic, and the latter deposited funds to the former’s bank account for bill paying on an erratic basis, ranging week-to-week from as low as $827 to as high as $12,000.
In April 2017, Justice Driscoll issued a decision and order (read here) finding that the parties’ conflicting factual allegations concerning the dissolution claim required an evidentiary hearing. Following completion of discovery, in early August 2018, Justice Driscoll issued a decision and order (read here) denying the parties’ dueling motions for summary judgment on petitioners’ dissolution claim, and also addressing a number of non-dissolution claims.
The Post-Trial Decision
Justice Driscoll conducted a two-day bench trial on August 20 and 21, 2018. I mention the dates only because Justice Driscoll’s six-page post-trial decision was issued the same day the trial ended, on August 21st. Blink, dear readers, and you may think I’m describing a proceeding in the Delaware Court of Chancery.
After reciting his factual findings, Justice Driscoll’s legal analysis summarizes 1545 Ocean Avenue‘s contract-centric approach and its two-pronged standard for dissolution under the dissolution statute’s not-reasonably-practicable standard, i.e., management’s inability or unwillingness to reasonably permit or promote the stated purpose of the LLC to be realized or achieved, or continuing the LLC is financially unfeasible.
Quoting from 1545 Ocean Avenue‘s quotation of Matter of Arrow Investment Advisors, LLC, 2009 WL 1101682 (Del Ch Apr. 23, 2009), Justice Driscoll further observes that ‘[e]ven if the LLC has a broad purpose, dissolution of an LLC is permissible upon a ‘strong showing that a confluence of situationally specific adverse financial, market, product, managerial, or corporate governance circumstances make it nihilistic for the entity to continue.’”
As to Epic’s “stated purpose,” and given the absence of any written operating agreement, Justice Driscoll found based on the testimony at trial, not only that Epic was formed to operate a facility offering gymnastic training and related programs, but also to operate “a successful financial mechanism by which customers were regularly charged for the services they received, from which Epic could meet its expenses.”
The heart of Justice Driscoll’s ruling follows, in which he finds that the “financial mechanism” aspect of Epic’s purpose is no longer achievable, and that its continuation is “nihilistic” in light of its powerless dependency on BeyondEpic’s arbitrary funding decisions, stating:
Epic’s purpose has not been met for some time, particularly in light of Respondents’ creation of BeyondEpic. BeyondEpic has reduced Epic to an entity which operates solely at BeyondEpic’s sufferance. BeyondEpic, and it alone, determines when to fund Epic. BeyondEpic, and it alone, determines the amount of that funding. There is no agreement memorializing that funding obligation. And, BeyondEpic has a member who has no part of or monetary interest in Epic, and thus no apparent interest in keeping Epic as a going concern. In essence, BeyondEpic uses Epic’s assets without any binding responsibility to pay for them. Meanwhile, Epic has failed to meet its expenses, as demonstrated by its unpaid credit card bills of $38,000 that Nicole has personally guaranteed. Indeed, it appears that BeyondEpic has reduced Epic to a marionette to be manipulated at will by BeyondEpic. But Epic was not formed to be BeyondEpic’s puppet. In sum, inasmuch as Epic is “propped up” solely by the monetary infusions from BeyondEpic, it is, as 1545 Ocean Ave. stated, “nihilistic” for it to continue. Dissolution is thus appropriate, and the Court therefore orders that Epic is dissolved as of this date.
Justice Driscoll’s ruling concludes with invitations to both sides. First, he invites the petitioners to re-apply for appointment of a receiver to wind up Epic’s affairs, which he had denied previously. Second, citing the Second Department’s endorsement of equitable buy-out in the Mizrahi case, he invites respondents to apply for a buy-out of the petitioners’ interest in Epic. As of this writing, the only post-trial action taken by either side is a letter to the court from respondents’ counsel stating that the respondents “are offering a buyout to the Petitioners as per after trial discussions.”
In light of the outcome, one certainly can question whether the majority members in D’Errico did themselves an unnecessary disservice by setting up BeyondEpic (with or without bringing in a new owner with no interest in Epic) to control Epic’s finances without any contractual guidelines, instead of using their existing majority control under the applicable default rules of the LLC Law.
Also noteworthy in terms of heavy-handed tactics is the fact that, only a month before the trial, the respondents purported to enter into a binding operating agreement without the petitioners’ signatures, authorizing expulsion of members who fail to make additional capital contributions. In his earlier ruling denying summary judgment motions, Justice Driscoll gave the operating agreement short shrift, stating “the Court will not consider the ex post facto operating agreement submitted by Respondents, based on the Court’s conclusion that there is no basis in logic or law for this operating agreement to apply to the parties’ dispute.”
Finally, it’s been eight years since the court in 1545 Ocean Avenue authoritatively construed section 702’s standard for judicial dissolution of LLCs. Cases such as D’Errico teach us that the failed-purpose prong of the court’s contract-centric inquiry should be applied not mechanically, but flexibly to achieve equitable results in the face of the infinite variety of fact patterns that litigants bring to court.