Managing Members of Realty Holding LLCs Vanquish Self-Dealing Claims
June 28, 2021
Managing members of manager-managed New York LLCs owe default fiduciary duties of loyalty and care to non-managing members. Those duties can be modified by the operating agreement. Lawsuits brought by non-managing members against managing members require the courts in each instance to measure claims of fiduciary breach against the interplay of the default rules with the operating agreement’s provisions setting forth contractual duties and/or displacing default duties.
I have no empirical evidence to back it up, but from what I see in my business divorce travels, the proportion of realty holding LLCs that are manager-managed vs. member-managed is higher than other LLCs operating sales and service businesses. That may be because realty holding LLCs have greater attraction for passive investors. It’s also characteristic of many inter-generational family owned realty firms.
Whenever you have closely held, joint business ventures combining the capital of passive outside investors with the management of active inside investors, there’s greater potential for clashes over real or perceived management conflicts of interest and self dealing, more broadly referred to as agency costs. That, plus the fact that realty holding companies these days overwhelmingly are organized as LLCs, plus the fact that the New York metro area has one of the largest and most active real estate development markets in the country, may explain the frequency of lawsuits in the courts of New York brought by non-managing members against managing members of realty holding LLCs involving allegations of conflict of interest and self-dealing.
Without further ado, below I discuss two recent, noteworthy decisions by state and federal appellate courts in Manhattan in which non-managing members of realty holding LLCs sued managing members over allegedly improper self-dealing transactions. In both cases, the courts ruled in favor of the managing members.
Managing Member With Preferential Return Not Obligated to Sell Property to Preserve Member Equity
I don’t often get to write about federal court decisions in business divorce cases. Such cases generally do not involve disputes between citizens of different states — especially in cases involving LLCs, whose citizenship is that of each of their members — or claims arising under federal law, hence there’s no federal court jurisdiction. Even when there is diverse citizenship, if the suit is one for judicial dissolution, some federal courts including those in New York will dismiss the case under the Burford abstention doctrine, thereby forcing it to be re-filed in state court.
Najjar Group, LLC v West 56th Hotel LLC, recently decided by the U.S. Court of Appeals for the Second Circuit, is the exceptional case. It involves non-dissolution state law claims between citizens of different states who are co-members of an LLC not made a party to the lawsuit. Specifically, the plaintiff Najjar Group LLC (“Najjar”) is a Delaware LLC and 20% non-managing member of non-party BDC 56 LLC (the “BDC”). The defendant West 56th Hotel LLC (“West”) is a New York LLC and 80% managing member of BDC.
Najjar and West formed BDC as a New York LLC in 1997 for the purpose of constructing and operating a hotel in midtown Manhattan that became known as the Chambers Hotel. As consideration for its 20% interest, Najjar assigned to BDC its contract rights to acquire the parcel on which the hotel was built. Najjar otherwise did not assume any rights or responsibilities concerning the construction and management of the hotel. BDC’s operating agreement:
- gave West sole authority to manage BDC’s business and affairs;
- barred Najjar from suing to compel any sale of BDC’s assets;
- made West responsible for obtaining third-party financing to construct the hotel;
- to the extent of any such financing shortfall, required West to contribute all capital necessary to construct and operate the hotel for its first three years of operation; and
- included a waterfall provision that required BDC to apply net cash flow from operations first to repay capital contributions made by either member, at a compounding annual rate of 8 to 10 percent, before any return to members on their equity interests.
The members’ initial estimate, that West would need to contribute $4 million additional capital to construct the hotel, proved too low by a long shot. On top of about $19 million in third-party financing, West ended up contributing about $15 million. Najjar did not make any capital contributions nor did it object to West’s contributions.
The hotel opened for business in 2002. Over the following dozen years, that is, before Najjar brought suit in 2014, and during the years of litigation that followed, the available distributions to West from the hotel’s net cash flow never kept pace with its compound interest-fueled capital account which grew to over $54 million by the time of trial in 2019. Neither Najjar nor West ever received profit distributions on account of their membership interests. It was undisputed at trial that West’s capital account would wipe out any equity in the hotel upon a sale of the property, i.e., all net sale proceeds would go to West. As Najjar colorfully put it, West’s ever-increasing capital account “created a death spiral capital structure.”
Najjar sued West for breach of the implied covenant of good faith and fair dealing and for breach of fiduciary duty. Essentially, Najjar claimed that West as managing member preferred its own interests over Najjar’s by not selling the hotel once it became apparent that the hotel’s continued operation would destroy the value of Najjar’s equity interest in BDC.
The District Court’s Decision. After a bench trial, S.D.N.Y. Judge Ronnie Abrams issued an Opinion & Order dismissing Najjar’s complaint. The court found that West did not breach the implied covenant by continuing to operate the hotel rather than selling it while there was still member equity, despite its growing capital account balance, and that the evidence showed that Najjar and West “intended the specific bargained-for exchange of risks and benefits that the operating agreement memorialized.”
The court also found that West’s simultaneous roles as manager and sole capital contributor, which Najjar characterized as a conflict of interest, were mutually designed to accommodate Najjar’s desire to neither manage the project nor put any money into it. Wrote the court: “That [West] took actions consistent with these expressly negotiated, fully disclosed dual roles thus cannot fairly be described as bad faith self-dealing.”
The Second Circuit’s Decision. Najjar’s argument based on the implied covenant, that West’s continued operation of the hotel rather than sell it destroyed Najjar’s right to receive the fruits of the parties’ agreement, fared no better on appeal. The Second Circuit agreed with the District Court that Najjar failed to prove that, by not selling the hotel, West exercised its discretion in managing BDC “arbitrarily,” “irrationally,” or “malevolently” for its own gain in order to deprive Najjar of the benefits of their joint venture. Rather, as the District Court properly found, Najjar assumed the risk of not receiving distributions from the hotel’s operations if it performed poorly. The court also stressed that imposing liability for breach of the implied covenant for failing to sell the hotel was inconsistent with the operating agreement’s express provisions under which Najjar waived any right to bring suit to compel a sale of the LLC’s assets, i.e., Najjar cannot seek a damages remedy for failing to sell the property when it bound itself not to force a sale of the same property.
Najjar’s appeal also pressed its conflict-of-interest argument that West as managing member breached its fiduciary duty to prefer rights common to all members of the LLC over its own preferred rights to the LLC’s proceeds. In support, Najjar relied on the decision by the New York Supreme Court, Appellate Division in Nathanson v Nathanson in which the court let proceed a suit claiming that an LLC’s managing member had engaged in wrongful self-dealing by deferring payment of certain priority distributions so that interest on the unpaid distributions could accrue at a 12% interest rate. The Second Circuit disagreed, stating that Najjar’s fiduciary breach claim based on the LLC Law’s default rules “must be determined with reference to the terms of the [Operating] Agreement” under which West had no fiduciary duty to cease operating and to sell the hotel.
Managing Members Accused of Breaching Fiduciary Duty By Acquiring LLC’s Mortgage Loan
We now turn to a case of alleged self-dealing of a different kind, also involving a single-asset realty holding LLC.
Besen v Farhadian, decided last week by the Manhattan-based Appellate Division, First Department, involved a dispute among equal one-third members of an LLC that owns a six-story multi-family apartment building. The building was encumbered by a $2 million mortgage loan that matured in October 2017. Non-managing member Besen and managing members Farhadian and Doshi could not agree on a plan to extend the mortgage loan, or to pay it off, or to refinance with another bank.
To avoid a default, prior to the maturity date and without Besen’s knowledge, Farhadian and Doshi formed and capitalized a company (“Jackson”) that bought the bank loan. Jackson then quickly filed a foreclosure action against the LLC in which Besen unsuccessfully tried to intervene and in which the court found that Besen had “refused to cooperate thus preventing the extension of the loan.” After Besen failed to obtain an appellate stay of the foreclosure action, and on the eve of the foreclosure sale, Besen agreed to pony up his one-third share of the mortgage debt, the loan was paid off, and Jackson discontinued its foreclosure action.
In the meantime, Besen filed an action against Farhadian and Doshi for breach of fiduciary duty based on their alleged self-dealing and conflict of interest in connection with their acquisition of the mortgage loan. Farhadian filed a pre-answer motion to dismiss the claim, arguing that the loan’s acquisition did not contravene various provisions of the LLC’s operating agreement or any default fiduciary duty arising under the LLC Law or common law. The lower court denied the motion, finding that on a pre-answer motion to dismiss, the complaint’s allegations pleaded a viable claim that the managers’ actions may have been to the LLC’s and Besen’s detriment. Farhadian appealed.
In opposition to the appeal, Besen argued that Farhadian’s and Doshi’s purchase through Jackson of the mortgage loan, as part of an alleged plan to commence a foreclosure action against their own company, deprive the company of a legal defense, abscond with the LLC’s sole asset as part of a “rigged” foreclosure process, and generate default rate interest, constituted self-dealing and bad faith in breach of their fiduciary duty as managing members.
The Appellate Division disagreed with Besen in its ruling last week. Without addressing the propriety of the managers’ secret purchase of the mortgage loan and commencement of foreclosure proceedings, the decision reversed the lower court’s order and granted the dismissal motion on the ground that Besen “failed to adequately plead the damages that flow from any alleged breach of fiduciary duty.” Here’s how the court explained it:
[A]s the amended complaint states, the loan was already an encumbrance on the property and needed to be paid off shortly. After the loan was assigned to Jackson, the creditor changed but it still needed to be paid off. Instead, the matter is now resolved, the property was not sold in a “rigged” process or at all, the debt has been paid, and the LLC still has the property as its asset. There is no allegation in the amended complaint that the LLC was required to pay a default interest rate. In short, aside from speculation, Besen does not allege any damage by the managing members’ purchase of the note and mortgage.
Lessons From Najjar and Besen
Najjar is the more clear cut of the two cases, simply because the express provisions of the operating agreement supported the challenged decision of the managing member to continue the hotel’s operations notwithstanding its ever-increasing capital account that eliminated Najjar’s subjective expectation of a return on its equity interest. Najjar could have anticipated and tried to avoid that unhappy outcome ex ante, for example, by negotiating for a provision in the operating agreement requiring a sale of the hotel upon hitting a specified ratio or benchmark taking into account third-party debt, member capital accounts, and the hotel’s market value as determined by formula or appraisal. Ex post, Najjar also had the option to make its own capital contributions that would have reduced West’s capital account balance and given Najjar the same preferential return from the hotel’s net cash flow.
Besen would have been a tougher call, at least at the pleading stage of the case, if the mortgage debt hadn’t been paid off and if Jackson had proceeded with the foreclosure sale. Depending on the outcome of such contra-factual sale, one can imagine the need for a trial to determine whether the managing members overreached to their own advantage and to the detriment of the LLC or its non-managing member. On the other hand, had Jackson acquired the mortgage to avoid a default and simply continued the loan on the same terms, i.e., without charging a default interest rate, or as a bridge loan pending refinancing, in the absence of provision in the operating agreement expressly forbidding the loan acquisition it’s hard to see how that would constitute a breach of duty or cause any detriment to the LLC or any of its members. On the contrary, the managers could credibly argue that their action had a salutary purpose and effect by avoiding a bank foreclosure action and default rate interest.