Recent Decisions Enforce LLC Member’s Right of First Refusal, Restrict Partnership Accounting, and Allow Damages Claim for Breach of Oral Shareholders Agreement
May 30, 2023
Someday, perhaps, I’ll find the comedic inspiration to come up with a joke that begins, “An LLC, a partnership, and a close corporation walk into a bar . . ..” Until then, I’ll have to satisfy myself with writing about an LLC, partnership, and close corporation that walk into a blog, offering the following, short treatments of three recent decisions of interest by New York courts:
- The first, involving an LLC, features a dispute arising from a somewhat unusual right of first refusal provision in an LLC operating agreement that authorizes an intra-member buyout of membership interests triggered by the receipt of an outside offer to purchase the LLC’s sole realty asset.
- The second, involving a partnership, addresses whether a partner of a dissolved law firm can seek an accounting of an alleged successor law firm formed without him by his former partners.
- The third, involving a close corporation, considers whether an alleged oral agreement to grow and manage a karaoke lounge without salary in exchange for a 25% equity interest if the venture became profitable, entitled the manager to 25% of the venture’s value following his ouster.
Court Enforces Right of First Refusal for Purchase of Membership Interests Triggered by Outside Offer for LLC’s Real Property
Last month, Brooklyn Commercial Division Justice Reginald A. Boddie issued a noteworthy Decision and Order in Orange Gowanus LLC v Ben-Yosef involving an action by an LLC member to enforce a right of first refusal to acquire its co-owners’ membership interests upon the LLC’s receipt of an outside offer to purchase the real property owned by the LLC’s wholly-owned subsidiary.
At a meeting of the members to consider the offer, two members voted to approve a straight sale of the realty for $27.5 million. The plaintiff voted to disapprove the sale.
Section 9.2 of the operating agreement (“Sale of the Project”) provided that if any member votes to accept an outside buyout offer, any non-approving member can give notice that it wishes to purchase the approving members’ membership interests “at a price equal to that which such Approving Members would individually have received if the Buyout Offer was accepted and effected and the Company was liquidated . . ..”
Following the vote the plaintiff gave notice of its election to acquire the approving members’ membership interests including an estimated calculation of the amount each would have received from a sale to the outsider upon liquidation of the LLC, and requesting a confirmation of the amount. The two approving members rejected the notice as untimely and on the ground the calculation of the amount due to the approving members was wrong.
The plaintiff filed suit for a declaratory judgment upholding its right to purchase the defendant approving members’ membership interests. The plaintiff alleged that it gave timely notice of its election within 15 days of the vote as specified in the operating agreement. It justified its estimated buyout price based on its lack of access to the LLC’s financial records. The plaintiff also contended that nothing in the operating agreement required it to calculate the amount due, much less that it do so with any specific degree of accuracy.
The defendants denied that the plaintiff lacked access to the financial records and alleged that the plaintiff purported to exercise its right to purchase their membership interests despite knowing that it lacked the funds to complete the purchase. Defendants also alleged that the notice of election was defective because it failed to include a release of defendants as guarantors under the existing mortgage on the LLC’s realty, unlike the outside buyer’s offer which included repayment of the existing mortgage.
Justice Boddie ruled in plaintiff’s favor, writing
Here, the operating agreement is unambiguous on its face and the parties do not dispute the relevant terms under the operating agreement. Plaintiff demonstrated that it followed the procedure to exercise the right to purchase defendants’ membership interest. Specifically, plaintiff informed defendants in writing that it wished to purchase their membership interest and provided an estimated price after it voted not to approve the sale to Rosen. Additionally, the Notice was delivered to defendants within 15 business days after the occurrence of said vote. Accordingly, plaintiff established that it properly exercised its contractual right to purchase defendants’ membership interest. In opposition, defendants failed to raise an issue of fact as defendants’ contention that the Notice is defective is not supported by the operating agreement. Based on the foregoing, plaintiff’s motion for judgment on its declaratory judgment claim is granted to the extent that the Notice is hereby declared valid. Plaintiff’s time to close on the purchase is tolled and plaintiff shall have four months upon notice of entry of this order to complete closing pursuant to section 9.2(c) of the operating agreement.
On the potential positive side, a right of first refusal like the one at issue in this case gives members a liquidity option based on an outside, market-driven valuation of the LLC’s sole realty asset, while giving members who prefer to maintain and enlarge their investment the option to realize a potential upside if the members seeking to liquidate their interests vote to accept a below-market offer.
On the potential negative side, the buyout provision’s structure, pricing mechanism, and terms:
- as with any right of first refusal, potentially discourage bona fide outside bidders,
- allow the non-approving member to offer to purchase the approving members’ membership interests at an indefinite liquidation value to be determined later rather than a direct purchase of the LLC’s realty at specified price and terms matching the outside offer,
- as a practical matter and unless otherwise agreed, necessitate a full accounting and closing of the books as of the buyout closing date,
- require agreement on pro forma closing costs of the realty conveyance and liquidation costs of the LLC, and
- fail to address potential issues concerning mortgage covenants and guarantees.
While not necessarily presenting insurmountable obstacles to a peaceful transaction, the potential negatives pose a possibility if not likelihood of dissension and litigation, as occurred in this case.
Partner of Dissolved Law Firm Loses Bid to Require Accounting by Alleged Successor Law Firm
Imagine a law firm with half a dozen partners that operated for 42 years as an at-will general partnership without a written partnership agreement. Actually, you don’t have to imagine it because that describes the Albany law firm known as Walsh and Hacker (WH) that found itself the subject of an action by partner Robert Thomson after his five other partners executed a notice of dissolution and on the same date formed a new law firm without Thomson called Walsh and Hacker & Associates, LLP (WHA).
According to Thomson’s complaint, WHA assumed control over WH’s assets including its office space, computers, equipment, technology networks, business relationships, website, accounts receivable and cash accounts, and
diverted these valuable assets to themselves and to WHA.
Thomson’s complaint asserted claims against WH, WHA, and his five former partners seeking an accounting of both firms and for conversion, constructive trust, unjust enrichment, and breach of fiduciary duty. On defendants’ pre-answer motion, Albany County Commercial Division Justice Richard M. Platkin issued a Decision & Order dismissing all claims save the accounting action against WH. The court reasoned that the non-accounting claims in advance of a full accounting were premature and that Thomson had no accounting remedy against WHA, “a partnership formed after [WH’s] dissolution in which plaintiff never was a partner” [italics in original].
In his subsequent appeal to the Appellate Division, Third Department, Thomson challenged the dismissal of his accounting claim against WHA on the ground it was authorized by Partnership Law § 74 providing that a partner is entitled to an accounting “as against the winding up partners or the surviving partners or the person or partnership continuing the business, at the date of dissolution, in the absence of agreement to the contrary” [italics added].
In its decision handed down earlier this month rejecting Thomson’s appeal, the panel agreed with the lower court that, “while plaintiff was entitled to the accounting of [WH], he has no right to a separate accounting of WHA, a firm in which he was never a partner and with which he has no confidential or fiduciary relationship.”
The decision’s one saving grace for Thomson appears in a footnote noting that Thomson “is not foreclosed from seeking nonparty discovery from WHA of evidence that is material and necessary to his claims against [WH].” Presumably, this is of some assistance to Thomson’s pursuit of his allegations that his former partners improperly transferred WH assets to WHA.
Court Denies Corporation’s Motion to Dismiss Complaint Alleging Breach of Oral Agreement for 25% Equity Stake
The owners of a corporation that operates a Manhattan karaoke lounge may be singing the blues after last month’s decision by Manhattan Supreme Court Justice Arlene Bluth denying their motion to dismiss a lawsuit brought by an ousted club manager who claims he was promised a 25% equity interest in exchange for his services.
In Lee v Park, the plaintiff’s complaint alleged that in 2013, the two defendants who owned the business orally agreed that if plaintiff would grow and manage the lounge and forego any monetary compensation, plaintiff would receive a 25% equity interest if he was able to make the lounge a profitable venture.
The plaintiff further alleged that in 2015, when the lounge became profitable, consistent with the agreement he started receiving 25% of the business’s profits, but that three years later the defendants ousted him from the business and stopped paying his profit share.
The plaintiff’s complaint asserted a $1 million damages claim for breach of contract and unjust enrichment, seeking to recover his 25% share of the value of the business.
The defendants moved for a summary judgment of dismissal, arguing that the plaintiff never made any capital contribution and was an employee of the lounge, not a part owner, and that the plaintiff held himself out as such on his tax returns, his divorce filing, and his loan applications.
In opposition and in support of his cross-motion for summary judgment, the plaintiff offered an audiotape of a conversation with the defendants supporting his claims of a “partnership” agreement predicated on his “sweat equity” in working without compensation and turning the failing business into a profitable one.
Justice Bluth’s decision denied each side’s motion, finding triable issues of fact arising from the lengthy period plaintiff worked without compensation, the defendants’ failure to offer payroll records once they started to pay him weekly, and unanswered questions about the significant amount of cash distributions made to the plaintiff. The court thus concluded,
In summary, there are issues of fact as to the nature of the parties’ agreement. Was it an agreement for 25% of the value of the business, as plaintiff argues? In that event, he is still entitled to the value of his 25% as of the date he left? Or is it as defendants argue, that eventually plaintiff bargained for a salary of 25% of the profits, which ended when he left. The factfinder must decide who and what to believe. The factfinder may believe that plaintiff, an experienced entrepreneur in the “club” business, was brought in to make the business profitable and was promised a piece of the business once he accomplished that goal and that is why he worked for
free for eight months: because he believed it would pay off in the end. Or the factfinder may believe what the defendants generally assert, that plaintiff was an off-the-books employee and made plenty of money by getting a 25% share in the profit in cash while he was working there but is entitled to nothing more.
The plaintiff’s note of issue demands a jury trial, highlighting the absence of any equitable claim enforcing a continued right to plaintiff’s recognition as a 25% shareholder — which makes consummate sense given the ongoing hostilities and the passage of years since the plaintiff’s alleged ouster.