Outlawing of LLC’s Short-Term Rental Business Brings Long-Term Litigation
December 10, 2018
After two years, 300+ docket entries, and 12 motions, a lawsuit among members of a Delaware LLC that owned a 5-story apartment building on Manhattan’s Upper East Side (the “UES Building”) acquired to provide short-term rentals for international leisure and corporate travelers, and whose business was decimated by anti-Airbnb legislation, is barely past the pleadings stage and likely can look forward to years more litigation.
Manhattan Commercial Division Justice Jennifer G. Schechter’s recent decision in Favourite Ltd. v Cico, 2018 NY Slip Op 32781(U) [Sup Ct NY County Oct. 30, 2018], permitting the LLC and some of its members to file an amended pleading against the LLC’s former managing members, addresses several issues of interest including whether the legislature’s action automatically triggered dissolution under the operating agreement’s arguably conflicting provisions, and whether the former managers’ attempted reinvestment of proceeds from the UES Building’s sale in another property violated the operating agreement’s purpose clause.
According to the Second Amended Complaint ultimately allowed by the court, the two defendants as sole managing members of Upper East Side Suites, LLC, formed in Delaware in 2007, solicited investors from Italy’s business community who contributed $4.75 million to buy the UES Building to operate a short-term rental business. What allegedly followed is a scheme by the defendants of “self-dealing, mismanagement, waste of assets, fraud, and forgery that resulted in the loss of every cent of the $4.75 million invested.”
The alleged scheme involved loaning funds to the LLC at above-market rates, diverting income to the defendants’ separately-owned entities, and failing to make promised distributions to the members in the early years of operation. Beginning around 2012, the operation suffered a mortal blow from an amendment to New York’s Multiple Dwelling Law aimed at curtailing the burgeoning business of short-term rentals via Airbnb by owners and occupants of New York City apartments.
The plaintiffs allege that the defendant managing members, instead of fulfilling their fiduciary duty at that point by selling the UES Building and distributing the net proceeds to members, continued to operate the business illegally for a time before defaulting on the mortgage, leading to a foreclosure action and a distressed sale of the property for less than market value. The defendants then allegedly used the $1.1 million in net proceeds as a down payment on a contract to purchase for $19 million a downtown Manhattan hotel property to be owned by a newly formed LLC — apparently with the intention that the original LLC’s members would have a direct or indirect ownership interest therein — and requiring a substantial investment to close the sale. To date, the investment has not materialized and the $1.1 million in proceeds from the sale of the UES Building supposedly remain in escrow.
The Plaintiffs’ Claims
Plaintiffs filed suit in 2016 following a vote by the members to remove the defendants as managing members. I’ll spare readers details of the case’s convoluted procedural history in which, initially, the LLC was a named plaintiff, after which it was dropped in the First Amended Complaint because it no longer had legal representation, after which a majority of the members authorized the LLC to engage new counsel and re-enter the case by means of a motion for leave to file the Second Amended Complaint primarily asserting claims in the name and right of the LLC.
The LLC’s proposed cause of action for breach of the Operating Agreement alleges that the defendants’ use of the UES Building sale proceeds to invest in the hotel property violates section 1.3’s purpose clause which states in relevant part:
The purpose of the Company is to acquire, hold, manage, operate, finance, develop, maintain and sell the [UES Building] and other real property . . .. The Company shall exist only for the purpose specified in this Section, and may not conduct any other business without the unanimous consent of the Members.
The LLC contends that the clause’s authorization to engage in transactions involving “other real property” does not authorize the defendants to use UES Building sale proceeds to acquire the hotel property in the name of a different entity, absent the (missing) unanimous consent of the members.
The LLC’s contract breach claim also contends that the sale of the UES Building should have triggered the LLC’s dissolution under sections 8.1 (b) and 8.1 (d) of the Operating Agreement, the former calling for dissolution upon “the sale of all of the Company’s assets and the collection and distribution of all proceeds therefrom” and the latter requiring dissolution upon “the occurrence of any event which makes it unlawful for the business of the Company to be carried on,” in this case the legislative ban on the LLC’s short-term rental business.
The LLC also proposed a second cause of action against the former managing members for breach of the fiduciary duties of loyalty and care based on insider loans at excessive rates and other acts of self-dealing, as well as risking forfeiture of the LLC’s $1.1 million down payment by the putative seller of the hotel property.
The proposed Second Amended Complaint also includes claims by the individual members for fraud at the outset by lying about their intentions of making distributions and later by misrepresenting the status of the sale proceeds, and for inspection of the LLC’s books and records apparently still in the defendants’ possession.
The Court’s Decision Permitting Leave to Amend
The defendants raised a number of arguments in opposition to the plaintiffs’ motion for leave to amend. With one exception, Justice Schechter accepted none of them.
Subject Matter Jurisdiction. The defendants initially argued that, even in the absence of a forum selection clause, Delaware courts have exclusive jurisdiction over plaintiffs’ claims governed by Delaware law concerning the internal affairs of a Delaware LLC. Justice Schechter gave the argument short shrift, writing, “Defendants are wrong. Disputes concerning the internal affairs of Delaware LLCs are routinely litigated in New York” and citing a number of case authorities.
The LLC’s Standing. The defendants next argued that the LLC lacked standing to sue under § 18-803 (b) of the Delaware LLC Act because it had been administratively dissolved by the Delaware Secretary of State in 2016. The argument fell flat, however, because a certificate of revival had been filed in April 2018.
The Purpose Clause. The defendants argued that their attempt to acquire the hotel property was consistent with the Operating Agreement’s purpose clause permitting them to acquire “other real property,” and that the LLC’s claim therefore was meritless. Justice Schechter disagreed, first, that the provision could be read in isolation from section 8.1 (d) requiring the LLC’s dissolution “if its business becomes illegal — which occurred prior to the sale of the [UES] Building.” Second, even if section 8.1 (d) did not require immediate dissolution, the defendants “did not merely have the [LLC] purchase another building.” Rather, she continued,
they used the sale proceeds as a down payment on the New Building, the purchase of which requires millions of additional dollars of funding from new investors. In essence, [defendants] were signing the [LLC] and its members up for a new venture in which they would be minority stakeholders in [the new acquisition company]. This is hardly a routine real estate transaction, as the very nature of the members’ investment was fundamentally changing. The [LLC’s] members would be forced into a new business with new investors and have different rights. Plaintiffs reasonably contend that this is impermissible under section 1.3 absent unanimous member consent. . . . Accordingly, plaintiffs’ claims that the [defendants] violated section 1.3 is not clearly devoid of merit.
Breach of Fiduciary Duty. Justice Schechter also rejected defendants’ argument against permitting plaintiffs to plead claims for breach of fiduciary duty that supposedly are duplicative of the contract claims. The claims for breach of fiduciary duty as pleaded, the court found, are based on a “broader” set of facts and are not expressly governed by the Operating Agreement which not only does not disclaim the managing members’ fiduciary duties it expressly “reaffirms” them. Justice Schechter did find, however, that the fiduciary breach claim was defective insofar as it alleged that the defendants loaned funds to the LLC at an excessive interest rate, since section 3.3 of the Operating Agreement expressly governs the interest rate on such loans, and also in regard to the alleged self-dealing contract between the LLC and defendants’ separate company, the propriety of which is governed by section 5.7.
Inspection of Books and Records. The court also allowed the plaintiff members to proceed on their direct claim for inspection of the LLC’s books and records, finding that section 6.1 of the Operating Agreement “indisputably” supports their right of inspection.
Fraud. The defendants met success only in regard to the plaintiff members’ direct claim for fraud, with the court finding that “[a]t most, this is a claim about the [defendants] being insincere about their intention of abiding by the Operating Agreement” rather than stating a valid claim for fraudulent inducement of their investments in the LLC, and that the claim was derivative rather than direct insofar as it alleged that defendants later lied about the status of the sale proceeds. In a footnote of interest, Justice Schechter viewed skeptically the parties’ assumption that the fraud claim was governed by New York law rather than Delaware, but seeing no conflict between the two proceeded to apply New York law.
The Road Ahead. This is a case to watch as it heads slowly to trial or summary judgment following discovery. The defendants filed a notice of appeal from Justice Schechter’s ruling and also subsequently made a new motion to dismiss the LLC’s claims in the Second Amended Complaint on the ground, among others, that because the LLC is manager-managed, the members’ written consent directing the LLC to bring the lawsuit against the defendants is ineffective, which raises an interesting question about whether they were replaced and by whom. The written consent recites that the members removed the defendants as managers but does not indicate their replacement, possibly because the Operating Agreement delegates to the remaining managers the right to replace a removed manager. No remaining manager, ergo no replacement, ergo a manager-managed LLC with no manager?
Why Not Dissolution? You may be wondering why the lawsuit by the non-managing members does not include a claim for judicial dissolution under § 18-802 of the Delaware LLC Act based on the failure of the LLC’s stated purpose and the apparent inability under the Operating Agreement’s terms to appoint a replacement managing member. The answer is simple: under New York case law, its courts lack subject matter jurisdiction to dissolve foreign business entities, meaning a dissolution action would have to be brought in Delaware where likely there’s no jurisdiction over the New York LLC formed by the defendants to acquire the hotel property and in whose name was made the $1.1 million down payment.
Justice Schechter. Finally, I’m pleased to see that Justice Schechter, who succeeded to the inimitable Justice Shirley Kornreich’s Commercial Division part upon her retirement earlier this year, is following in her predecessor’s footsteps by producing written decisions of the highest quality evidencing careful examination of the parties’ positions, great attention to detail including substantive footnotes à la Delaware Chancery Court opinions, and scholarly discussion of legal authorities.