Operating Agreement Spawns Multiple Disputes Between 50/50 Members of Realty Holding LLC
November 11, 2019
330 West 85th Street is a prime location on Manhattan’s Upper West Side. At that address sits an elegant, pre-war, 48-unit rental apartment building known as The Rexmere. A 4th floor one-bedroom apartment currently is available for $2,950 per month, if you’re interested. I get no commission.
330 West 85 also is the name of the limited liability company that owns the building. The LLC in turn is owned by two gentlemen, Harvey Rubin and James Baumann. Rubin and Baumann’s father acquired the building in the late 1970’s as partners in a general partnership.
Baumann subsequently succeeded to his father’s partnership interest. In 1996, he and Rubin converted the partnership to a manager-managed LLC in which each holds a 50% membership interest and each is a designated manager. The building today undoubtedly is worth exponentially more than its 1978 purchase price.
The business relationship between the two owners apparently went smoothly until around 2014 when Rubin, by then a widower in his 80s, decided to “retire” and approached the younger Baumann about a buy-out. Thus began a chain of events that ruptured their relationship and sees them currently entering their fifth year of litigation marked by two round trips to the appellate court.
The first appellate decision in 2017 pronounced Baumann the winner in a dispute over the construction of the operating agreement’s provisions governing the lifetime sale of a member’s interest.
The second appellate decision last week pronounced Rubin the winner in a dispute centering on the application of LLC Law § 408(b)’s default rule for manager decision-making, to the parties’ dispute over Baumann’s refusal to give up his longtime position as the building’s managing agent.
In both appeals, it’s fair to say that shortsighted drafting of the operating agreement sowed the seeds of dispute. I’ll offer some more thoughts about that at the bottom of this post.
According to Rubin’s later-filed affidavit, after his wife died in September 2014, he approached Baumann about selling his membership interest for $6.5 million which supposedly was “well below the real market value.” Baumann’s $5 million counter-offer supposedly “upset” Rubin who in turn countered with a $7 million offer to acquire Baumann’s interest. Baumann rejected Rubin’s counter.
In May 2015, Rubin hired counsel who sent Baumann a formal “Sale Notice” of Rubin’s desire to sell his interest in the LLC for $8.65 million. The notice invoked Section 8.5.1 of the Operating Agreement which authorizes “Offering Members” to notify the “Managers” of their desire to sell at an “Offer Price,” and gives the “Managers” 120 days to accept the offer.
Baumann did not accept the offer within the time permitted. Rubin then asserted his “right” under Section 8.5.3 of the Operating Agreement to require the LLC to offer the building for sale at a “Target Price” sufficient to net the Offering Member a distribution upon liquidation “a sum no less than the Offer Price” after deducting costs of sale and satisfaction of mortgage debt. Under the provision, if the building is not sold within 6 months, it must be withdrawn from the market and no member can give another Sale Notice for the next 2 years.
According to Rubin, Baumann blocked his efforts to obtain building access, leases, and other information necessary to market the building. Baumann also allegedly rejected Rubin’s demand to allow him to co-manage the building with Baumann or, alternatively, to replace Baumann’s separately-owned company as managing agent with an outside agent.
Rubin filed suit in November 2015. His complaint sought to compel Baumann to cooperate with the sale of the building for a 6-month period under Section 8.5.3. It also sought $10 million as damages “due to lost [sale] opportunities” and to enforce Rubin’s claimed right to co-manage the building or to appoint an independent managing agent.
The First Appeal: Baumann Prevails
In July 2016, the lower court granted partial summary judgment in Rubin’s favor on his claim to enforce the LLC’s obligation to market the building for sale under Section 8.5.3. The court’s decision rejected the “technicalities” raised by Baumann’s opposition and found that Rubin’s Sale Notice and subsequent demand that the LLC market the building for sale “met the specifications of the operating agreement.”
Rubin’s partial victory was short-lived. Baumann appealed to the Appellate Division, First Department, which, in March 2017, unanimously reversed the lower court’s order.
The appellate panel based its ruling on Rubin’s failure to comply with Section 8.5.2 of the Operating Agreement — a provision not mentioned in the lower court’s decision — requiring Rubin to give a second notice of his desire to sell. The second notice is required to be given to the “Members” instead of the “Managers” as required by Section 8.5.1, even though Baumann is the only other Member and the only other Manager. Here’s the relevant language from Section 8.5.2:
If the Managers elect not to purchase the Interest of the Offering Members as above described [under Section 8.5.1] and if the Offering Members still desire to sell the Interest, the Offering Members shall give the other Members a Sale Notice, and the other Members shall have thirty (30) days after their receipt of the Sale Notice to agree to purchase the Interests that the Offering Members wish to sell at the Offer Price set forth in “the Sale Notice, pro rata, according to their respective Percentage Interests. [Emphasis added.]
The court found that Baumann’s interpretation — that “the other Members” means “Members other than the Offering Members” — makes “at least as much sense” as Rubin’s interpretation that “the other Members” means “Members who are not Managers.” Since “the contract is ambiguous [and] cannot be construed as a matter of law,” Rubin “was not entitled to summary judgment.”
The court also found nothing “absurd,” as Rubin argued, about requiring him to serve a second Sale Notice to Baumann as a Member, adding that “it would merely give Baumann an additional 30 days (beyond his 120 days as Manager) to purchase [Rubin’s] interest in [the LLC].”
The Second Appeal: Rubin Prevails
Rubin subsequently agreed to the dismissal of his causes of action to require a sale of the building and to require Baumann to account, leaving as his sole remaining claim his request for an order making him co-managing agent of the property and for a share of the managing agent fees taken by Baumann.
Earlier this year, Baumann moved for summary judgment dismissing Rubin’s last surviving claim. Baumann averred that in 2001, he and Rubin agreed to appoint Baumann’s separately-owned management company, called WinWin Asset Management LLC, as managing agent for the building and that WinWin has managed the building ever since.
Under Section 3.1.1 of the Operating Agreement, “the business and affairs of the Company shall be conducted and managed solely by the Managers” except for certain major decisions reserved to the Members. Baumann argued that, because the Operating Agreement is silent concerning the appointment or replacement of a managing agent, Rubin’s claim is governed by the default rule in LLC Law § 408(a) stating that management shall be “by affirmative vote of a majority of the managers.” Therefore, the argument went, no change can be made to the managing agent without the unanimous consent of the two managers — Rubin and Baumann.
The lower court disagreed in a June 2019 Decision denying Baumann’s summary judgment motion. Even assuming Baumann is correct that a majority vote is required to replace WinWin as managing agent, the court reasoned, by the same token a majority vote is required to keep WinWin as managing agent “as this is also a major management decision for the LLC.”
Baumann appealed to the First Department whose decision last week upheld the lower court’s ruling essentially on the same basis:
[Baumann’s] argument is unavailing. Even if the Operating Agreement is “silent” with respect to the replacement of Managers and the default provisions of the LLCL apply, the continued decision to keep Win Win Asset Management LLC as the managing agent of the company is also a major management decision for the Company, and requires a majority vote. Given that Rubin and Baumann each hold a 50% ownership stake in the Company, the parties are deadlocked as to this fundamental decision regarding its operations.
The court agreed that Rubin’s damages claim, for a share of management fees taken by Baumann, also survives. “If the contract had not been breached,” the court wrote, “[Rubin] would have either been paid to manage or would at least have saved half of the fees paid to the management company.”
(For those interested, video of the appellate argument of the 2019 appeal is available here starting at the 16:18:50 mark.)
Where Did the Operating Agreement Go Wrong?
To my mind, the oddest feature of the provisions for lifetime sale of a member’s interest was not among the ones litigated in the case. Rather, I was taken aback that Section 8.5 authorized a Sale Notice even while the ink was still drying on the Operating Agreement, potentially leading to a required sale of the building. Giving non-controlling owners of a realty holding company an immediate, at-will right to liquidity can be a perilous affair, for a number of reasons.
That aside, I’ve seen many operating (and shareholder) agreements that include a two-stage right-of-first offer, first to the company and, if the company’s managers (or directors) take a pass, then to the members (or shareholders). The Operating Agreement in the Rubin case was unusual in that the first-stage offer was to the Managers, not to the LLC. Why the Managers? I have no clue, especially since the Operating Agreement elsewhere provided that a Manager need not be a Member.
It’s somewhat understandable that Rubin sent only one of the two required Sale Notices to Baumann given the fact that Baumann was both the only other Manager and the only other Member. As the appellate court pointed out in its 2017 decision, the “ambiguous” wording in Section 8.5.2 (“give the other Members a Sale Notice”) supported each of the parties’ contradictory readings. Nonetheless, a more cautious approach would have been to send both Sale Notices at the cost of an extra 30 days before requiring the LLC to market the property for sale.
As to the managing agent issue, from my cursory review of the record in the case, it appears that Baumann owned the prior managing agent at the time of the conversion to an LLC as well as the managing agent that took over in 2001. I also noticed no reference to any written management agreement between the LLC and either of Baumann’s companies.
It’s not unusual for real estate investors to own property management companies to service their own buildings. When they do, and when ownership of the building is not fully aligned with ownership of the property manager, there’s a potential divergence of interest between the realty holding company owners who do and do not own the property manager. Those who don’t co-own the property manager should insist on a written management agreement with the realty company for a fixed term on commercially reasonable terms. Consideration also should be given to requiring the approval of a majority in interest of members who do not co-own the property manager to approve any decisions to remove or replace the managing agent.
What comes next for the litigation-weary owners of 330 West 85? Will Rubin re-start the sale process under Section 8.5, or has he already done so? Will he file for judicial dissolution of the LLC, citing the Appellate Division’s statement that the two 50/50 members “are deadlocked as to this fundamental decision regarding its operations”? Or perhaps it’s time for Rubin and Baumann to make a deal, with or without the aid of a mediator. We’ll just have to wait and see.