Operating Agreement Defeats Statutory Buyout Rights Upon LLC Member’s Withdrawal
December 11, 2017
When the tsunami of LLC enabling statutes swept the U.S. in the late ’80s and early ’90s, including New York in 1994, many included a default rule authorizing as-of-right member withdrawal and payment for the “fair value” of the membership interest. The default rule was one of many designed to avoid C corporation-style “double taxation” of LLC earnings. After 1997, when the IRS adopted check-the-box regulations cementing pass-through partnership tax treatment for LLCs, New York and other states flipped the default rule, i.e., members are no longer permitted to withdraw unless authorized by the operating agreement.
When New York amended its withdrawal provision, LLC Law § 606, it included a new subsection “b” grandfathering LLCs formed before the amendment’s 1999 effective date, meaning that withdrawal under the “old” § 606 and fair-value buyout under LLC Law § 509’s default rule remain available for members of pre-1999 LLCs — so long as not otherwise provided in the operating agreement. The Chiu case, which I wrote about here, is an example of one such case resulting in a fair-value buyout of a withdrawn member.
After the amendments, some pre-1999 New York LLCs adopted new operating agreements or amended their existing ones to prohibit withdrawal. Some, as in Chiu, did not.
This is a story about one LLC that did not, but with a very different outcome than Chiu. The story’s punch line, which makes it a fascinating one, is that even though the minority member, seeking to force a fair-value buyout, was found to have properly invoked his uncontested right to withdraw under the old § 606, in the end the lower and appellate courts held that his withdrawal did not trigger a statutory buyout under § 509 because the LLC’s operating agreement included mandatory rights of first refusal — with which the minority member never complied — that displaced the buyout statute’s default rule.
The case, Matter of Jacobs v Cartalemi, was decided last week by the Appellate Division, Second Department, along with two decisions in companion appeals in related cases in which the court held that upon withdrawal the minority member also lost his standing to pursue derivative claims against the controlling member. I’ll explain all below, but before doing so I must disclose that, along with co-counsel, my firm and I represent the controlling member of the LLC in each of the cases.
Jacobs involves an LLC formed in 1995 to acquire, improve and operate a 12-acre parcel of commercial and industrial real property in Westchester County, New York called the Westchester Industrial Complex. The LLC had two members: Charles Cartalemi, the managing member holding an 80% interest, and non-managing member William Jacobs holding a 20% interest.
The LLC’s operating agreement did not include any provision regarding withdrawal or otherwise altering the statutory default right of a member under the old § 606 to withdraw upon six-months notice. It did, however, include membership interest transfer restrictions in Article 10.
Section 10.01 of the LLC’s 1995 operating agreement included a provision entitled “Right of First Refusal” that started off with the sentence, “In the event any Member . . . desires to sell his, her, or its Membership Interest, the Selling Member shall first be required to adhere to the terms of this section.” Two subsections followed, setting forth first refusal rights under scenarios with and without a third-party offer.
Subsection 10.01(a), captioned “Sale of Membership Interest in Absence of Prior Offer,” required the Selling Member who has not received a third-party purchase offer to make a written offer to sell to the other member setting forth the proposed terms and conditions. The other member has 30 days either to reject the offer or make a counter-offer. If a counter-offer is made, the Selling Member has 30 days to accept or reject it. If rejected, the Selling Member is then free to sell to a third-party on terms no less favorable to the Selling Member than the counter-offer received from the other member. If no third-party transaction occurs within 120 days thereafter, the Selling Member cannot dispose of his or her membership interest without starting anew under Section 10.01.
Subsection 10.01(b), captioned “Sale of Membership Interest Where Selling Member Receives Prior Offer,” required a Selling Member who receives a bona fide third-party purchase offer to offer to sell to the other member on the same terms and conditions as the third-party offer. If, within 30 days, the other member rejects the offer, or makes a counter-offer which the Selling Member rejects, the Selling Member is then free to sell the membership interest to the third party on the terms no less favorable than the written offer. As in Section 10.01(a), if no third-party sale occurs within 120 days thereafter, the Selling Member cannot dispose of his or her membership interest without starting anew under Section 10.01.
Section 10.01 provided a sole exception to its requirements, for a lifetime or testamentary transfer of a membership interest to an immediate family member.
The First Two Lawsuits
Relations between the two members went relatively smoothly for the first 17 years of the LLC’s existence. That changed around 2012, when Jacobs filed the first of two lawsuits asserting what he styled as direct and derivative claims against Cartalemi seeking damages for breach of fiduciary duty, waste and mismanagement of the LLC’s assets, including taking excessive management fees and personal use of the LLC’s building without paying rent. Cartalemi denied all allegations of wrongdoing and asserted affirmative defenses and counterclaims.
In 2014, Jacobs filed a second damages lawsuit against Cartalemi asserting additional claims styled as direct and derivative for fiduciary breach, principally in connection with the assignment of the mortgage following settlement of a foreclosure proceeding against the LLC’s realty. Again, Cartalemi denied all allegations of wrongdoing and asserted affirmative defenses and counterclaims.
Jacobs’ Notice of Withdrawal and Declaratory Judgment Action
In March 2015, out of the blue Jacobs served Cartalemi with a written notice of withdrawal from the LLC and demand for payment of the fair value of his 20% interest. Jacobs’ notice requested Cartalemi’s “consent” to his withdrawal but went on to state that, with or without consent, Jacobs’ withdrawal would become effective December 1, 2015, at which time Jacobs would commence a proceeding to compel a fair-value buyout by the LLC under § 509. Jacobs did not offer to sell his membership interest to Cartalemi or otherwise attempt to comply with Section 10.01(a) of the operating agreement.
Cartalemi did not agree that Jacobs was entitled to a fair-value buyout upon withdrawal and therefore did not consent, following which, in July 2015, Jacobs filed a third lawsuit against Cartalemi and the LLC seeking a judgment declaring his right to withdraw from the LLC under old § 606 and to be paid the fair value of his membership interest (without any discounts) under § 509.
Cartalemi’s Dismissal Motions
Jacobs’ notice of withdrawal by its terms became effective December 1, 2015. Soon afterward, Cartalemi filed dismissal motions in all three lawsuits in which he acknowledged the effectiveness of Jacobs’ withdrawal and argued that the procedures for right of first refusal in Article 10 of the operating agreement displaced the default fair-value buyout provision in § 509.
There being no New York case authority directly on point, Cartalemi relied on a 2014 opinion by the 6th Circuit U.S. Court of Appeals in Bellwether Community Credit Union v CUSO Development Co., LLC where, under similar circumstances, the court held that the operating agreement’s terms superseded statutory buyout rights upon the minority member’s withdrawal. Cartalemi also argued that all of Jacobs’ claims in the first two lawsuits were derivative and, consequently, when Jacobs withdrew as a member he lost standing to maintain them.
In a series of decisions by Westchester County Commercial Division Justice Linda S. Jamieson, the court agreed with Cartalemi that Article 10 displaced § 509; that Jacobs’ demand for a fair-value buyout in his third lawsuit therefore had no merit; and that all of the claims in Jacobs’ first and second lawsuits, except for two in the first action, were derivative and therefore could not be maintained by Jacobs upon withdrawal. The decisions in chronological order, including two addressing motions for reconsideration, are available here, here, here, here, and here.
Jacobs filed appeals in all three actions. Cartalemi filed a cross appeal as to the two surviving claims in the first action.
The Appellate Rulings
The gist of Jacobs’ appeals was that, because the LLC’s operating agreement was silent on the issue of withdrawal, he was entitled to a fair-value buyout under § 509’s default rule. Article 10 of the operating agreement, Jacobs argued, only applied to a sale of a membership interest to a third party and was not intended to supplant § 509. Jacobs also argued that his standing to sue derivatively survived his withdrawal and/or his claims could be asserted individually.
In three separate opinions the appellate court unanimously rejected all of Jacobs’ arguments. In its decision in the third suit rejecting his § 509 buyout demand (read here), the court held that Section 10.01(a) of the operating agreement was “unambiguous on its face” and “establishes procedures to be used where a member has not received an offer of sale, but nonetheless wishes to relinquish her, his, or its membership interest and to be compensated for the same.” Therefore, citing with approval the 6th Circuit’s Bellwether ruling, the court wrote:
regardless of whether the “selling member” has withdrawn as a member of [the LLC], the operating agreement provides the manner in which the member might receive value for the membership interest (cf. Bellwether Community Credit Union v CUSO Development Co., LLC, 566 Fed Appx 398 [6th Cir]). Accordingly, the Supreme Court properly determined that Jacobs was not entitled to a judgment declaring that, upon his withdrawal from [the LLC], he is entitled to be paid, within a reasonable time, the fair value of his membership interest in accordance with Limited Liability Company Law § 509, together with interest at nine percent per annum, without the application of any discount factor.
Jacobs fared no better in his two other appeals. The court agreed with Cartalemi in both (read here and here) that all of Jacobs’ claims were derivative and therefore could not be maintained following his withdrawal. The court’s opinion in the earlier of the two actions borrowed freely from well-established doctrine applying the continuous ownership rule in shareholder derivative actions. Since this appears to be the first New York appellate ruling applying the doctrine in the context of member withdrawal from an LLC, I here quote in full that portion of the court’s opinion:
“[M]embers of a limited liability company (LLC) may bring derivative suits on the LLC’s behalf” (Tzolis v Wolff, 10 NY3d 100, 102). In a derivative suit, “[t]he remedy sought is for wrong done to the corporation; the primary cause of action belongs to the corporation; [and] recovery must enure to the benefit of the corporation” (Isaac v Marcus, 258 NY 257, 264; see Marx v Akers, 88 NY2d 189, 193). In the context of a corporation, “the standing of the shareholder is based on the fact that . . . he [or she] is defending his [or her] own interests as well as those of the “corporation” (Tenney v Rosenthal, 6 NY2d 204, 211; see Independent Inv. Protective League v Time, Inc., 50 NY2d 259, 263). “Where the plaintiff voluntarily disposes of the stock, his [or her] rights as a shareholder cease, and his [or her] interest in the litigation is terminated. Being a stranger to the corporation, the former stockowner lacks standing to institute or continue the suit” (Independent Inv. Protective League v Time, Inc., 50 NY2d at 263-264 [citations omitted]; see Tenney v Rosenthal, 6 NY2d at 211). The same is true in the context of an LLC. In order to maintain a derivative cause of action, a plaintiff must be a member of the LLC (see Herman v Herman, 122 AD3d 506, 507; Billings v Bridgepoint Partners, LLC, 21 Misc 3d 535, 540 [Sup Ct, Erie County]; cf. Maldonado v DiBre, 140 AD3d 1501, 1504; Ciullo v Orange & Rockland Utils., 271 AD2d 369; Rubinstein v Catacosinos, 91 AD2d 445, 447, affd 60 NY2d 890). Thus, the Supreme Court properly held that, once the plaintiff withdrew from [the LLC], he lost standing to maintain any derivative causes of action on behalf of the company, notwithstanding his possible right to a future payment for the value of his membership interest upon his withdrawal (see Billings v Bridgepoint Partners, LLC, 21 Misc 3d at 540; Howe v Bank of New York Mellon, 783 F Supp 2d 466, 477 [SD NY]).
The most important lesson of Jacobs for LLC members and their counsel when it comes to withdrawal and its consequences is the obvious one: look carefully at the operating agreement before you leap. Chances are, for LLCs formed after the effective date of the 1999 amendment to § 606, the operating agreement will not authorize as-of-right withdrawal, thereby mooting the possibility of a § 509 fair-value buyout. However, for LLCs like the one in Jacobs that pre-date the amendment — and there remain many out there, either without operating agreements or with operating agreements still in effect that don’t prohibit withdrawal — before considering withdrawal it’s critical to determine whether the operating agreement contains any transfer restrictions that might override the default right to a fair-value buyout under § 509 and/or dictate a buyout on unfavorable terms.
Update September 13, 2018: The New York Court of Appeals — the state’s highest court — today denied Jacobs’ motion for leave to appeal from the Appellate Division’s dismissal of his action seeking to enforce his claimed right to be bought out for fair value under LLCL § 509.