Judicial Dissolution and the Weaponized LLC
September 24, 2018
What’s a weaponized LLC? It’s one whose operating agreement gives the controlling majority members the authority to dilute, remove from management, or expel a non-controlling minority member, typically for failing to satisfy a mandatory capital call or engaging in conduct the majority determines to be a breach of specified standards of conduct.
Weaponization can occur openly or stealthily. Openly, the dilution, removal, or expulsion powers are spelled out explicitly in the operating agreement signed by all the members. Stealthily, the operating agreement authorizes amendment of the operating agreement by the majority, i.e., without minority consent, effectively allowing such powers to be added at a later time of the majority’s choosing.
Few tears normally are shed when a minority member is diluted, removed from management, or expelled under the express provisions of an operating agreement to which the minority member knowingly subscribed. As the saying goes, you made your bed, now lie in it.
Does the minority member hit with the stealth variety via an amendment to which he or she never consented deserve any greater sympathy? More importantly for litigators, does the majority’s adoption and implementation of such measures for the purpose of squeezing out the minority member, or otherwise gaining leverage in a dispute not necessarily related to the LLC’s governance and business affairs, provide the minority member with grounds to seek judicial dissolution of the LLC?
Not according to Manhattan Commercial Division Justice Saliann Scarpulla whose decision last month in Yu v Guard Hill Estates, LLC, 2018 NY Slip Op 32008(U) [Sup Ct NY County Aug. 15, 2018], dismissed a minority member’s claim for judicial dissolution of two family-owned, realty-holding LLCs under Section 702 of New York’s LLC Law. The decision found insufficient as a matter of law the complaint’s allegations that the majority members — the plaintiffs’ siblings — were motivated by personal “vendetta” when they adopted and implemented amendments to the operating agreement removing the plaintiff as co-manager and authorizing a mandatory capital call leading to foreclosure of the membership interest of the financially strapped plaintiff.
The complaint filed by Patrick Yu against his brother Raymond and sister Catherine centered on an LLC that owns a remainder interest in their parents’ residential property in Bedford, New York and another LLC that holds title to a Manhattan apartment building where the parents and the two sibling defendants also resided. Patrick held a one-third membership interest in the former LLC and a one-fifth interest in the latter LLC.
The complaint describes a series of intra-family squabbles commencing in 2013 pitting Patrick against his parents and siblings who, allegedly, “out of personal animus” toward Patrick, “use[d] every means at their disposal to marginalize Patrick’s role at the LLCs, to divest Patrick of his ownership stake in those entities, and to defeat Patrick’s reasonable expectation that he would realize some economic benefit from the ownership stake” in the LLCs’ two properties and in a third company that funds the family’s various real estate and business activities.
Patrick alleged in critical part that both LLCs “were created as entities wholly owned by the Yu children so that the Yu parents could transfer their interest in the Bedford and [Manhattan] properties to their children for tax and/or other reasons.” He further alleged that he “understood” that the LLCs “were to be passive entities meant solely as holding companies,” i.e., not generating revenue or incurring expenses, and not requiring funding by their members.
As family tensions ratcheted up, allegedly in “retaliation” for a books-and-records inspection demand made by Patrick, his siblings amended the LLCs’ 2-page, mirror-image operating agreements to remove Patrick as a managing member and by adding a provision authorizing the siblings as the remaining managing members to make a mandatory capital call at their sole discretion, and if the demand is not met, foreclosing the membership interest of the non-contributing member.
The amendments were made without Patrick’s consent or signature in accordance with identical provisions in the original operating agreements — made many years before the outbreak of family friction — stating that “No amendment to this Agreement shall be effective unless made in a writing duly executed by the holders of not less than 51% of the membership interests of the Company.”
Soon afterward, the siblings made a $590,000 per member capital call to retire the mortgage and reimburse their parents for capital improvements to the Bedford residence. In his complaint, Patrick alleged that the capital call was made “to retaliate against and oppress Patrick” for exercising his statutory right to demand an inspection of books and records; that it was “out-of-step with [the LLC’s] purpose as an entity — which is to passively hold the Yu Family’s Bedford country estate”; and that his siblings knew Patrick did not have the funds to contribute.
Following the capital call and Patrick’s failure to make the demanded contribution, the siblings sent Patrick notices tracking the amended operating agreement’s remedial provisions authorizing the siblings to advance funds secured by a lien on Patrick’s membership interest subject to foreclosure.
Patrick then added to the growing menagerie of pending litigations with his family by filing for judicial dissolution of the two LLCs, principally contending that his siblings were unwilling or unable to permit the LLCs’ “stated purpose” to be achieved and that, instead, they were using the LLCs “as a weapon to exert pressure on and oppress a minority owner.” As further grounds for dissolution, Patrick alleged his siblings’ refusal to provide him with access to books and records, and he accused them of making inordinate payments for travel and entertainment expenses.
The Court’s Dismissal of the Lawsuit
The siblings filed a pre-answer motion to dismiss the complaint, arguing that its allegations failed to state a valid claim for judicial dissolution under LLC Law § 702’s not-reasonably-practicable standard as construed by the courts in the 1545 Ocean Avenue case and its progeny. They laid particular emphasis on the purpose of the LLCs as found in the operating agreements, the one stating that the LLC is formed “for the purpose of acquiring a remainder interest” in the Bedford property “and engaging in any and all activities necessary or incidental to the foregoing,” and the other using comparable language as concerns the Manhattan property. They also argued that the complaint’s allegations of oppressive conduct by the siblings, while relevant under the statute governing judicial dissolution of a closely held corporation, have no application under § 702 as per cases such as Doyle v Icon and Matter of Kassab.
Patrick opposed the motion, denying that his claim was one based solely if at all on “oppression”; insisting that both LLCs were designed as passive holding companies intended to serve as an “estate planning tool to transfer real property between generations of the Yu family”; asserting that his siblings were pursuing a “personal vendetta” against him while enriching themselves at his expense; and arguing that the complaint’s factual allegations met the pleading standard for judicial dissolution under § 702.
Patrick’s argument gained no traction with Justice Scarpulla who granted the siblings’ motion and ordered entry of judgment dismissing the complaint. Here’s what she wrote:
Given the broad language in the operating agreements, Patrick has failed sufficiently to plead the requisite grounds for dissolution of the LLCs in his complaint. He does not adequately allege that the LLCs are not operating in a manner within the contemplation of their purposes and objectives as defined in their respective operating agreements, or that continuing their operation would be financially unfeasible. He provides no factual support or basis which would support an allegation that the individual defendants are unable or unwilling to promote the purpose of the LLCs or that it is not reasonably practicable to carry on the business of the LLCs in conformity with the operating agreements.
While Patrick complains that his family members have been engaged in certain activities to further their personal “vendetta” against him, his unflattering characterization of his family’s actions is not sufficient to support a cause of action that his family has abandoned the purpose of the LLCs and/or rendered the operation of the LLCs financially unfeasible.
Some Further Thoughts
- I have no information and therefore no opinion as to the reasons for, or the wisdom of, the inclusion in the subject LLCs’ operating agreements of a provision authorizing amendment by majority rather than unanimous consent. Was it deliberately inserted at the parents’ insistence based on a belief that their children would be unable to achieve consensus to deal with unknown, future events necessitating changes to the operating agreement? We’ll never know. But I can say with certainty that, absent the amendment provision, under New York law Patrick would not have faced a mandatory capital contribution or the adverse consequences of his failure to contribute.
- The amendment provision typically is nestled among the miscellaneous “boilerplate” found at the tail end of the operating agreement. The Yu case is a powerful reminder to pay careful attention to every word when vetting a proposed operating agreement. The price for not doing so potentially is even higher when contemplating taking a non-controlling interest in a “weaponized” LLC.
- The court’s summary dismissal of the complaint in Yu draws an interesting comparison with the Mace v Tunick case also involving an action to dissolve a real estate holding LLC in which the appellate court reversed a summary dismissal and ordered a trial to hear conflicting evidence concerning the LLC’s purpose. In that case, the operating agreement merely stated that the LLC’s purpose was “any lawful business” which the court said was tantamount to no purpose. In Yu, in addition to the standard “any lawful business” language, the purpose clauses in both LLC agreements specifically referred to the acquisition and holding of a specific real property interest, thus avoiding the Mace conundrum.