Operating Agreement Dooms Derivative Claims by Deceased LLC Member’s Estate
April 16, 2018
In business divorce litigation, petitioners / plaintiffs often want to start the case with a bang. A common tactic is to file a petition / complaint simultaneously with an injunction motion. Often there is a real need for an injunction – the respondent / defendant may be engaging in activities that could cause real, irreparable harm.
But often another objective is that if the injunction motion succeeds, it will be an early win in the case, set the stage favorably for the litigation to come, put significant leverage on the respondent / defendant by restricting its freedom to operate the business, and possibly result in a speedier resolution of the case. If the injunction motion or complaint itself has vulnerabilities, however, a case meant to start with a bang may end with an unceremonious whimper. That is just one lesson from a recent decision by Manhattan Commercial Division Justice Saliann Scarpulla in Pappas v 38-40 LLC, 2018 NY Slip Op 30329(U) [Sup Ct NY County Feb. 22, 2018]).
The Pappas Case
In Pappas, The 38-40 LLC (the “LLC”), owned three real properties in Long Island City, New York. The LLC had a written operating agreement. Kirsch owned 70%, Pappas 25%, and Glendis 5%. Pappas died. Not long after, his wife, Debbie Pappas (“Debbie”), the personal representative of Pappas’ estate, sued the LLC and its members. In a complaint alleging nineteen claims in encyclopedic fashion, Debbie purported to sue “as Personal Representative of the Estate of Louis Pappas, individually and derivatively on behalf of The 38-40 LLC.” In her affidavit, Debbie alleged that before Pappas’ death, Kirsch caused the LLC to transfer two of the three real properties owned by the LLC to another entity not owned by Pappas, and to take out a $3 million mortgage on the third property without Pappas’ consent. Immediately after filing the complaint, Debbie filed a motion to enjoin the members “from taking any action to diminish the value of, or to dissipate any of the property owned by The 38-40 LLC,” to “maintain the status quo during the pendency of the action,” and to appoint a temporary receiver to take control of and operate the LLC.
May a Deceased LLC’s Member’s Executor Sue Derivatively?
Pappas raised an important yet infrequently-litigated legal question: May the executor of a deceased LLC member’s estate sue the LLC or its members in a derivative suit – that is, on behalf of the deceased LLC member’s estate, derivatively on behalf of the LLC?
Under Section 608 of the Limited Liability Company Law, the default rule is that when an LLC member dies, “the member’s executor . . . may exercise all of the member’s rights for the purpose of settling his or her estate or administering his or her property, including any power under the operating agreement of an assignee to become a member.” In Crabapple Corp. v Elberg, 153 AD3d 434 [1st Dept 2017], one of the scarce cases to consider LLC Law 608, the court held that the majority LLC member’s “interest in the LLCs passed to his estate upon his death,” so “the co-executors of the estate had the authority to act as co-managers of the LLCs” in place of the decedent. Crabapple did not decide whether a deceased member’s executor may sue derivatively on behalf of the LLC. But the court did hold in broad terms that “Limited Liability Company Law 608 provides that the executor of a deceased member may exercise all of the member’s rights for the purpose of settling his or her estate” (emphasis in original). Assuming the operating agreement does not act as a complete bar, could an executor of a deceased LLC member fashion a derivative claim “for the purpose of settling his or her estate”? There doesn’t seem to be any New York case precedent addressing the issue, so we’ll just have to wait and see.
The Operating Agreement
As always, an operating agreement may opt out of the LLC Law’s default rules. In Pappas, the LLC’s operating agreement did just that. Some of its provisions regarding death of a member actually resembled the default rules under the Partnership Law, written about in an earlier post, particularly that the death of a member “shall terminate” the LLC unless the members “shall elect to continue the business.” Section 16 of the operating agreement defined “the death . . . of a Member” as a “Withdrawal Event” and provided:
In the event of a Withdrawal Event with respect to any Member, any successor in interest to such Member (including without limitation any executor, administrator, heir, committee, guardian, or other representative or successor) shall not become entitled to any rights or interest of such Member in the Limited Liability Company other than the allocations and distributions to which such Member is entitled, unless such successor in interest is admitted as a Member in accordance with this Agreement.
The Continuous Ownership Rule
Relying upon section 16 of the operating agreement, the defendants opposed Debbie’s motion for an injunction with a cross-motion to dismiss the complaint for lack of standing. Under the so-called “continuous ownership rule” for standing, as articulated by the court:
To pursue a claim derivatively on behalf of a limited liability company, a plaintiff must be a member of the limited liability company at the time of the alleged wrong, at the commencement of the lawsuit, and throughout litigation.
(quotations and citations omitted).
Relying solely upon the operating agreement, which Justice Scarpulla held sufficiently “explicit and unambiguous” to constitute “document evidence” for a motion to dismiss, the court held:
As expressly provided in Operating Agreement § 16, Pappas’s membership in the LLC terminated upon his death on October 31, 2015. The Operating Agreement also expressly provides that Plaintiff, as Personal Representative of the Pappas Estate, is a successor in interest only, and is entitled to Pappas’s allocations and distributions but not his membership rights or interests. Under the plain terms of the Operating Agreement neither Plaintiff nor the Pappas Estate are Members of 38-40 LLC, thus Plaintiff lacks standing to pursue derivative claims on 38-40 LLC’s behalf.
The court also held that Debbie could not avoid the continuous ownership rule by trying to plead some of her claims directly, writing, “A shareholder or LLC member may not sue in his/her/its individual capacity to remedy a harm against a business entity – the claim must be brought derivatively.” The court ultimately agreed with the defendants that “although Plaintiff asserts several direct causes of action, these causes of action are actually derivative, and Plaintiff lacks standing to pursue them.” As a result, the court dismissed the complaint in full.
What can an executor of a deceased LLC member’s estate – relegated to the position of a mere “interest holder” or “assignee” – do when it believes the LLC or its members have engaged in wrongdoing? An earlier post, available here, addressed the plight of such a person seeking access to the LLC’s books and records. The short answer is that LLCs, members, and their counsel should anticipate and carefully address the death of a member, and the rights of the deceased member’s estate, in the operating agreement. In Pappas, had the operating agreement included some kind of a mechanism for a buyout of a deceased member’s interest in the LLC, such as an appraisal, litigation might have been avoided entirely.