Recent Decisions Enforce LLC Member’s Right of First Refusal, Restrict Partnership Accounting, Invalidate Shareholder’s Post-Mortem Buyout
May 29, 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, applies a buyout-upon-death provision in a shareholders agreement to the validity of an alleged buyout agreement by one shareholder after the death of another, where the putative buyer himself died before the buyout was consummated.
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 a straight 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 purchase the approving members’ membership interests at an indefinite liquidation value 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.
The Grim Reaper Plays Havoc With Shareholder Agreement’s Buyout Provision
Shareholders agreements often include a provision requiring the estate of a deceased shareholder to offer the decedent’s shares to the surviving shareholders and, should the latter not acquire the shares, requiring the corporation to purchase them based on pricing and terms specified in the agreement.
The Grim Reaper played a starring role in Kaloidis v Kaloidis, decided last month by Manhattan Supreme Court Justice Louis L. Nock. He of the fearsome scythe appeared not once but twice in succession, first, to claim the life of Shareholder #1, thereby triggering negotiations and an alleged agreement with surviving Shareholder #2 to acquire the estate shares. Then, before the buyout was consummated and amidst litigation brought by Shareholder #2 to enforce the buyout, Shareholder #2 died thereby triggering a buyout demand by the corporation at the behest of the other surviving shareholders.
Prior to his death Shareholder #2 filed suit for specific performance of the allegedly binding buyout agreement of Shareholder #1’s estate shares after the other surviving shareholders objected to the buyout and insisted that, because not all the surviving shareholders exercised their buyout option, under the express terms of the shareholders agreement the corporation had the sole right to acquire the estate shares.
While suit was pending, Shareholder #2 died. Following substitution of the proper estate representatives, the estate of #2 moved for summary judgment enforcing the alleged buyout of #1’s estate shares, and the estate of #1 cross-moved for summary judgment dismissing #2’s buyout claim.
Justice Nock’s decision last month denied #2’s motion and dismissed the action per #1’s request:
- First, the court found that the pre-litigation negotiations between Shareholder #2 and #1’s estate representative never reached a meeting of the minds and ripened into an enforceable agreement.
- Second, the court found that the alleged agreement was never reduced to a writing signed by an authorized representative of #1’s estate and therefore ran afoul of the Statute of Frauds in § 5-703 of the General Obligations Law applicable to the sale of shares of a closely held corporation whose only asset is real property.
- Third, construing the shareholders agreement as authorizing only a living shareholder or the corporation to purchase the shares of a deceased shareholder, the court held that “[w]hile [Shareholder #2] had the right to enforce the [buyout agreement] when he was alive, his claim has been mooted due to his death.”