LLC’s Purpose Being Achieved? Business Doing Fine? Good Luck Getting Judicial Dissolution
October 02, 2017
New York’s LLC judicial dissolution statute, Section 702 of the Limited Liability Company Law, provides far more limited grounds to dissolve a business than the Business Corporation Law – a harsh reality for allegedly mistreated minority members highlighted by a recent decision by Manhattan Supreme Court Justice David B. Cohen.
In Matter of Felzen v PEI Mussel Kitchen, LLC, 2017 NY Slip Op 31831(U) [Sup Ct, NY County Sept. 1, 2017], Felzen sued to dissolve the company that operates a pair of Manhattan seafood restaurants named Flex Mussels, based upon allegations of breach of fiduciary duty, looting and oppression – frequent grounds for dissolution under Section 1104-a of the Business Corporation Law. In Matter of Zafar, an earlier decision written about on this blog, comparable allegations – i.e., “persistent self-dealing and dishonest conduct” – sufficed to dissolve an LLC. Let’s see how things turned out here.
PEI Mussel Kitchen LLC was a seven-member LLC formed in 2009. It had a written operating agreement under which husband and wife restauranteurs, the Shapiros, owned 1% and 50%, respectively, with their daughter owning another 12%, for a total Shapiro family interest of 63%. Felzen owed 12% and three other members collectively owned the remaining 25%.
The operating agreement’s “purpose” clause stated that the LLC was formed “to develop and operate a restaurant . . . and possible future restaurants with a . . . mussels and seafood theme . . . .”
The three Shapiros were the managing members. Under the operating agreement, the “general business and affairs” of the LLC were manager managed, but the agreement also stated that “[m]ajor decisions other than with respect to day to day operations shall be made by a majority in number of the Members holding 70%” of the membership interests.
The operating agreement prohibited transfer of any member’s interest “without the prior written consent of all the other Members” and stated that a transfer in violation of transfer restrictions “shall be null and void.”
The operating agreement prohibited changes to the agreement unless “agreed to by the affirmative vote or consent of the Members holding 70%” of the membership interests.
According to Felzen, the Shapiros illegitimately acquired the 25% interest owned by the three other members, increasing their collective ownership interest to 88%, in violation of the transfer restrictions in the operating agreement. Once they did so, they began to pay themselves exorbitant compensation through excessive salaries, management fees, and use of company funds for personal expenditures. Felzen claimed that the Shapiros acquired Ashkenazy, Krieger and Schuster’s interests solely to exceed the 70% threshold required to amend the operating agreement. Once they exceeded the 70% threshold, they unilaterally adopted an amended operating agreement severely impairing Felzen’s voting and economic rights in the company.
Initially, Felzen filed a derivative complaint, alleging claims for an accounting and breach of fiduciary duty. But Felzen quickly withdraw his derivative suit and filed a proceeding for dissolution, noting in his petition, “I have previously filed a shareholder derivative suit, but have determined that it is in the best interests of the LLC to proceed by dissolution at this time.” Felzen sued under LLC Law 702, but his pleading was full of language from the BCL:
- “[T]he directors or those in control of the LLC have been engaged in illegal, fraudulent or oppressive actions toward the complaining member” (compare BCL 1104-a [a] ).
- “[T]here is such internal dissension among the members [and/or] directors of the LLC that dissolution would be beneficial to the members” (compare BCL 1104 [a] ).
- “As a consequence of the behavior and events of the type specified . . . liquidation of the LLC is the only feasible means whereby the Petitioner may reasonably expect to obtain a fair return on his investment” (compare BCL 1104-a [b] ).
After more than a year of discovery, Felzen filed an amended petition, alleging a single claim for dissolution, but seeking a cavalcade of non-dissolution remedies, most notably: (i) an order declaring the Shapiros’ purchase of the other three members’ 25% interest null and void; (ii) an order reallocating the membership interests; and (iii) an injunction prohibiting the Shapiros from using company funds for personal expenses, receiving salaries, or paying themselves management fees.
The amended petition largely ignored the “purpose” clause of the operating agreement – i.e., “to develop and operate a restaurant . . . with a . . . mussels and seafood theme . . . .” Rather, Felzen alleged, “[T]he Shapiro Owners have starved the Company of capital to grow the business, and as a result, it is not able to operate for its stated purpose.”
The Dismissal Motion
The Shapiros moved to dismiss the amended petition. Their brief argued that Felzen failed to plead, and could not show, the standard for dissolution under LLC Law 702 because “the purpose of the Company” as stated in the operating agreement “is to develop and operate a restaurant.” To show that the company was achieving its stated purpose, the Shapiros used Felzen’s own earlier derivative complaint against him, in which Felzen admitted:
- “The Company operates a highly regarded restaurant called Flex Mussels on West 13th Street in Manhattan.”
- “The company is known as “very popular” and upon information and belief is doing very well. Upon information and belief the Company had gross sales of over $2,100,000.00 in 2011 and $2,400,000.00 in 2012.”
In his opposition brief, relying upon Matter of Zafar, Felzen argued that dissolution is appropriate “when the subject limited liability company has been used solely for a member’s own benefit.” Felzen argued that the Shapiros’ “persistent self-dealing and dishonest conduct render the Company incapable of carrying on in conformity” with the operating agreement.
In his decision, Justice Cohen recited the now-familiar standard for LLC dissolution – the petitioner “must establish, in the context of the terms of the operating agreement or articles of incorporation, that (1) the management of the entity is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved, or (2) continuing the entity is financially unfeasible” (In re 1545 Ocean Ave., LLC, 72 AD3d 121, 131 [2d Dept 2010]).
Applying this standard, the court held:
Petitioner is not entitled to dissolution, pursuant to § 702, as the stated purpose and business of the LLC was to ‘develop and operate’ restaurants . . . . The petition does not make any allegations that reflect that the purpose of the Company is not or cannot be realized or achieved. As such, respondent’s motion to dismiss the dissolution cause of action for failure to state a claim is granted.
Despite dismissing the dissolution claim, the court allowed much of the rest of the amended petition, including the accounting claim – which Felzen alleged years earlier in his derivative lawsuit – to proceed. The court also allowed Felzen to proceed with his claim concerning the Shapiros’ allegedly improper acquisition of the other three members’ 25% membership interests, but ordered Felzen to amend his pleading to name them as parties to the lawsuit.
Minority members who feel abused by the majority often find dissolution claims attractive because they believe the threat of dissolution – especially of a thriving business – will provoke their opponent to negotiate a buyout or some other form of compromise rather than risk the business’s demise. Mussel Kitchen is a reminder to would-be petitioners that allegations which may be sufficient to dissolve under the BCL are often not enough under the LLC Law. If the LLC is achieving its contractually-stated purpose, and remains a financially viable operation, the odds of surviving summary dismissal on a claim for dissolution diminish greatly. Of course, the unavailability of a dissolution remedy does not necessarily affect the potential viability of claims for breach of common-law fiduciary duty, accounting, or contractual claims which often provide sufficient leverage to achieve the dissident member’s strategic goal.