Text Messages Trump Formalities in Ownership Dispute Over Cryptocurrency Business
June 13, 2022
The emergence of the Limited Liability Company as the preferred form of closely-held business association in New York has spawned a glut of litigation over disputed membership status in LLCs, many of which are covered in the pages of this Blog (here and here, for starters). Non-existent or ignored operating agreements, lack of certificated ownership interests, and the informal deals that seem prevalent among LLC members provide prime conditions for a fight over membership in an LLC.
Disputes over membership in LLCs often feature one faction—the party disputing the claimed membership—citing to the operating agreement or requirements for admission to membership that were not satisfied, and the other faction—the party claiming membership—relying on some other agreement or representation. In Sobel v Tulchiner (covered here), the defendant pointed to an operating agreement declaring himself the sole member, while plaintiff relied on a Department of Health Application stating that he was one of multiple members. In Cupcake v Boomboom (covered here), the plaintiff looked to an operating agreement identifying the members, while defendant relied upon a submission to the State Liquor Authority identifying different members.
That brings us to a recent decision by New York County Justice Borrok, Sherman v Zampella, in which the court considers the plaintiff’s claim that text messages establish that he was a 9.9% member of an immensely valuable cryptocurrency business, despite the plaintiff’s admitted non-compliance with the member-admission requirements of the operating agreement.
Bitcoin ATMs and the Text-Message Deal
Cottonwood Vending LLC (“Cottonwood”) is New York’s largest provider of Bitcoin ATMs. Bitcoin ATMs look like traditional ATMs, but they allow the user to exchange fiat currency for cryptocurrency, or to trade one type of cryptocurrency for another.
According to Sherman’s Complaint, Cottonwood was founded by Zampella, but he lacked the technological skill to bring the Company’s vision to fruition. After a series of setbacks, Zampella asked Sherman to join Cottonwood as its CTO. At that time, Sherman alleged, he and Zampella entered into an oral agreement providing that Sherman would be paid $125,000 annually and receive a 9.9% membership interest in Cottonwood.
Though Sherman never signed Cottonwood’s Operating Agreement or otherwise reduced his deal to obtain a 9.9% membership interest to writing, Sherman pointed to text messages between Zampella and Cottonwood’s lawyers in which Zampella seems to confirm the parties’ agreement (or, at least, pending agreement):
Lastly, and we still need to have Latham draw this up, but: pending the license being granted due to [Sherman] coming on board & helping in other ways, he would receive 9.9% equity in Cottonwood to be vested at the time DFS gives the green light & approves us for a trip to the moon . . .
In accordance with their agreement, Sherman designed the code necessary to make Cottonwood a success, including the “brains” of the Bitcoin ATM—a network of cloud servers, security measures, data models, and a database—that allowed Cottonwood to both (i) operate securely and (ii) save on the substantial license fees it otherwise would have had to pay outside software companies to utilize a program similar to the one Sherman designed. Sherman was also instrumental in helping Cottonwood obtain its “BitLicense” from the state of New York, a prerequisite to live operations in New York.
Sherman Sues Derivatively on Behalf of Cottonwood, Minting Zampella’s Challenge to Sherman’s Ownership
After Cottonwood launched successful operations in New York, Sherman alleges that he uncovered Zampella’s scheme to raid Cottonwood of its assets. According to the Complaint, Zampella wrongly stated that Coindado—a Puerto Rican company wholly-owned by Zampella—rather than Cottonwood owned the software that Sherman developed. He then caused Cottonwood to enter into a sham license agreement providing Coindado with substantial licensing fees—more than $11 million as of September 2021—for Cottonwood’s use of that software. Sherman separately alleges that Zampella converted 180 Bitcoin ($7.8 million) to his personal Bitcoin wallet.
Sherman commenced suit derivatively on behalf of Cottonwood, seeking to recover fees paid under the sham license agreement and the 180 Bitcoin allegedly converted by Zampella personally.
Zampella moved to dismiss the derivative claims on the grounds that Sherman was not a member of Cottonwood and therefore lacked standing to commence an action for injury to Cottonwood.
In support of his argument (read here) that Sherman was not a member, Zampella cited two items: (i) K-1s demonstrating that he was the only member during the years 2016 through 2021 and (ii) Cottonwood’s Operating Agreement, which set forth certain restrictions on the admission of new members. Specifically, the Operating Agreement provided:
All members shall be required to sign this document.
. . .
[C]hanges in the Membership or percentage interests must immediately be included in amendments to this Agreement.
. . .
Each member shall be responsible for a capital contribution equal to his/her percentage interest.
. . .
Notwithstanding anything contained herein to the contrary, no person at any time shall be admitted as a Member of the Company unless: the person delivers to the Company a written instrument agreeing to be bound by the terms of this Agreement and any amendments thereto.
Sherman’s failure to allege that he ever signed the Operating Agreement or made a capital contribution—both prerequisites to membership under the terms of the Operating Agreement—was fatal to Sherman’s claimed membership interest in Cottonwood, Zampella argued.
Sherman disputed (read here) Zampella’s reliance on the formalities of the Operating Agreement on two grounds. First, he contended that by their agreement, he and Zampella orally amended the Operating Agreement to dispense with those formality requirements and make him a 9.9% member. Second, to the extent the Operating Agreement was not amended to dispense with those requirements, Sherman argued that Zampella waived those requirements, or that he should be estopped from relying on the formality requirements because he did not allow Sherman to comply with them. Specifically, he never recorded Sherman’s interest in an amendment or gave Sherman a copy of the Operating Agreement to sign.
Text Messages Trump the Formality Requirements of the Operating Agreement
New York County Commercial Division Justice Borrok denied Zampella’s motion to dismiss. Justice Borrok quoted extensively from text messages between Sherman and Zampella, including a 2020 exchange in which Zampella—albeit equivocally—seems to acknowledge Sherman’s interest:
Sherman: i own 10% of cottonwood, correct?
Sherman: so what makes you think i’m interested in just ‘cashing out’ for a few hundred k
Zampella: because that’s what you just said
Sherman: this is true, correct?
. . .
Sherman: you’re not answering my question
. . .
Zampella: 10% of like nothing is still nothing . . .
This exchange, the Court held, was:
[P]rima facie evidence that Mr. Sherman has an approximately 10% interest in Cottonwood and that any requirements set forth in the Operating Agreement for additional writings that were either never executed by the defendants (and therefore in breach of the Operating Agreement) or otherwise never provided to Mr. Sherman were waived.
Justice Borrok did not comment on Sherman’s contention that the Operating Agreement was amended, but adopted Sherman’s argument that Zampella’s failure to give Sherman a chance to comply with the formality requirements of the Operating Agreement precluded Zampella’s reliance on those requirements:
Stated differently, it does not matter at this stage of the proceeding that Mr. Sherman can not produce a written signed counterpart of the operating agreement that he was never provided by the defendants or that Mr. Zampella never executed an amendment to the operating agreement. Mr. Zampella can not fail to provide documents or fail to execute an Amendment to the Operating Agreement and then claim that no Amendment to the Operating Agreement was executed and that therefore Mr. Sherman is not a member.
Based on the parties’ text messages, the Court rejected Zampella’s argument that Sherman lacked standing to sue derivatively on behalf of Cottonwood because he was not a member. The Court granted Sherman leave to amend his complaint to clean up his claims against Zampella individually for misappropriation of Cottonwood’s assets.
Is Waiver a Trap for Single-Member LLCs?
LLC members often enter into an operating agreement containing certain formality requirements, then exercise substantially less formality in their dealings. In those cases, the argument—apropos Sherman’s argument here—that a member waived his or her right to insist upon the formality requirements of the operating agreement is a familiar one. Consider the Fourth Department’s in-depth waiver analysis in McGuire v McGuire (covered in this post).
Recall that prior to Sherman, Zampella was the sole member of Cottonwood. I suspect that single-member LLCs are far more susceptible to arguments that the sole member’s conduct waived certain provisions of the operating agreement, since it is not clear whether those provisions were bargained-for in the first place. The existence of other members in Cottonwood (who would be “adversely affected” by the admission of Sherman as a member, see LLCL § 417) might change the analysis here.
I also wonder whether the Court’s waiver analysis would have been different if Zampella tried to bootstrap the admission requirements of the Operating Agreement with LLCL § 602, which states that LLC members may be admitted “upon compliance with the operating agreement.” On the one hand, if the statutory requirements of the LLC law generally are not as waiveable as the requirements in an operating agreement, (see Waxman Real Estate LLC v Sacks, 32 Misc 3d 1241(A) [Sup Ct 2011]), and the LLC law requires, as section 602 does, “compliance with the operating agreement,” can the requirements of the operating agreement still be waived? On the other hand, the Court also found that Zampella could not invoke the formalities of the operating agreement because he failed to allow Sherman a chance to comply with them.
Get Counsel Early
Sherman v Zampella highlights an additional practice pointer for LLC members and their counsel: The Court considered 2020 text messages between the parties as probative of a 2018 agreement. Those text messages presumably occurred after the parties had assumed an adversarial posture, but before lawyers were retained. While parties often are reluctant to retain counsel in the early-stages of a dispute for fear of raising the temperature and thwarting a chance at resolution, Sherman demonstrates that cases can be won or lost in the window between when parties retreat to their corners and when counsel gets involved.