The Curious Case of the Expelled LLC Member Bound by Operating Agreement He Never Signed
February 03, 2020
The case of Shapiro v Ettenson ranks as one of the more consequential ones in the realm of New York’s LLC jurisprudence.
For those not familiar with the case, about which I’ve posted before here and here, in 2015 the lower court ruled, and in 2017 the appellate court affirmed, that Section 402 (c) (3) of New York’s LLC Law authorized two members holding a majority interest in a three-member LLC to enforce against the third member, who never approved or signed it, an operating agreement adopted almost two years after the LLC’s formation, including provisions for mandatory capital calls and member expulsion. The ruling stands as a stark reminder to those contemplating joining an LLC as a minority member not to do so without having a definitive written operating agreement in place at the time of joinder.
Within days of the appellate court’s affirmance, the majority members sent a notice to Robert Shapiro, the minority member, expelling him from the LLC. The notice stated, in sync with the operating agreement’s expulsion provision, that Shapiro “failed or refused to perform his duties and responsibilities as a Member or Manager” and “engaged in unauthorized and other bad faith conduct that has had (and is continuing to have) a material adverse impact on the business or affairs of the Company.”
Shapiro responded with a new lawsuit contesting the grounds for his expulsion and asserting direct and derivative claims for damages against the majority members. Last month — over two years after the suit’s commencement — Manhattan Supreme Court Justice David Benjamin Cohen issued a ruling granting in part and denying in part the defendants’ motion challenging Shapiro’s amended complaint. While finding that certain claims were precluded by the initial litigation, and dismissing others, the court kept alive Shapiro’s claim for wrongful expulsion and upheld his standing to assert derivative claims. Shapiro v Ettenson, 2019 NY Slip Op 33793(U) [Sup Ct NY County Dec. 23, 2019].
Shapiro’s complaint recites the history of the LLC’s formation by the three, co-equal members and commencement of business operations without an operating agreement in early 2012 as an exclusive distributor of an exercise and therapeutic device called the HyperVibe Whole Body Vibration Machine. Starting around September 2013, relations between Shapiro and his co-members deteriorated when the latter allegedly demanded a cut in Shapiro’s salary as part of a “scheme to force [Shapiro] out of [the LLC] and keep the profits of [the LLC] for themselves.”
The complaint then goes on to relate that, in late 2014, after the majority members adopted an operating agreement without Shapiro’s consent, cut off his salary, and made a capital call coupled with dilution for failure to comply, Shapiro brought his first lawsuit challenging the operating agreement’s validity and salary payments taken by the majority members. It also relates the lawsuit’s outcome adverse to Shapiro and, in its immediate aftermath, the majority members’ allegedly wrongful notice of expulsion.
The complaint asserted seven causes of action, including derivative claims to recover salary payments taken by the majority members and seeking damages for other alleged financial improprieties, along with direct claims for breach of the operating agreement in connection with the attempted expulsion, fraudulent conveyance, accounting, and breach of fiduciary duty.
The Expulsion Challenge Survives a Dismissal Motion
The majority members moved to dismiss the complaint in its entirety. As noted already, their motion succeeded insofar as Justice Cohen determined that Shapiro’s derivative claims to recover salary payments and other disbursements by the LLC for legal fees and business-related expenses were barred by claim and/or issue preclusion arising from the first lawsuit. Justice Cohen also dismissed the fraudulent conveyance claim for failure to state a valid claim, and the fiduciary breach claims as duplicative of Shapiro’s contract breach claims.
Not so for Shapiro’s claim for breach of the operating agreement in connection with his expulsion and for derivative claims not otherwise precluded by the first lawsuit.
The majority members made a two-pronged argument. First, they argued that, as an expelled, former member, Shapiro lacked standing to pursue derivative claims. Second, they contended that Shapiro “waived” his direct claims related to his expulsion by failing to follow the procedures and timeline in Article 13 of the operating agreement requiring arbitration of any dispute concerning a member’s expulsion or the “Fair Value Amount” to be paid an expelled member in redemption of his membership interest.
Justice Cohen disagreed. He found that Shapiro’s second cause of action predicated on wrongful expulsion is a direct rather than derivative claim “because plaintiff seeks to vindicate his individual rights” for breach of contract based on the allegation that “defendants failed to follow the dissociation procedures in the Operating Agreement.”
As to the question of Shapiro’s standing to pursue derivative claims, Justice Cohen observed that it “turns on his expulsion from [the LLC]” which in turn rests on the majority members’ contention that Shapiro lost his right to challenge his expulsion by not initiating arbitration as required by the operating agreement. Here again, Justice Cohen disagreed, writing:
Defendants’ argument that plaintiff failed to pursue arbitration is unpersuasive. . . . Counter to defendants’ assertion, section 13.03(d) does not place the burden of pursuing arbitration solely upon plaintiff. Rather, section 13.03(d)(i) provides, in relevant part, that the “remaining Members . . . and the Expelled Member shall mutually agree upon and designate an arbitrator not later than forty five (45) days following the Expulsion Date.” Plaintiff’s February 24, 2017 response to his expulsion should have alerted defendants to his intent to contest the issue, and under the plain reading of section 13.03(d), plaintiff and defendants were obligated to mutually select an arbitrator. Even though plaintiff did not submit a counteroffer on the value of his interest, nothing in section 13.03(d) precluded defendants from proposing a prospective arbitrator. Furthermore, if plaintiff rejected the arbitrator nominated by defendants, then section 13.03(d)(i) provides that “any party may apply to the American Arbitration Association, or any successor thereto, to designate a single arbitrator.” Defendants do not dispute that they failed to avail themselves of this provision.
Justice Cohen further explained that, while Shapiro’s initiation of litigation may have operated to foreclose him “from affirmatively pursuing his claim in an arbitral forum,” it did not foreclose him “from seeking redress in any venue” as defendants argued. “[G]iven their own inactivity,” he added, “defendants may have arguably waived their right to pursue arbitration as well.” Thus, even though the issue of Shapiro’s member status “is more properly determined in arbitration,” he concluded, “neither party has moved to compel arbitration or for a stay of this proceeding.”
On that note, Justice Cohen granted Shapiro leave to file a second amended complaint, pleading his constructive trust claim derivatively, and ordered the majority members to answer it within 20 days of service.
An End in Sight?
Seemingly not. The litigation between Shapiro and the majority members has entered its sixth year. Justice Cohen’s decision sets the stage for discovery and eventual trial which could take two or more years to complete, likely punctuated with additional motions and interlocutory appeals.
I’m in no position to know the stakes or say if they justify the time, effort, and expense. Only the parties can make that assessment. Only the parties know whether the passage of six years, during which presumably they’ve had little or no direct contact, has cooled the passions bred by the initial falling out. Only the parties know whether years more of legal fees on top of those incurred already call for a cold-eyed settlement before embarking on the next phase of litigation.
But whatever the outcome for the parties, let it be said, the case of Shapiro v Ettenson already has left an indelible mark on LLC governance when members launch their LLC without an operating agreement, as happens with greater frequency than you might think.