The LLC Equitable Buyout: Past, Present, Future
February 19, 2018
Under the right set of facts, New York courts occasionally find remedies for LLC owners not explicitly authorized in the Limited Liability Company Law (“LLC Law”). Judges have a natural inclination to try to find solutions for legal problems where existing law falls short, which is part of how the common law came to be.
One striking example is the LLC derivative cause of action. In Tzolis v Wolff, 10 NY3d 100 , the Court of Appeals ruled that members of an LLC “may bring derivative suits on the LLC’s behalf, even though there are no provisions governing such suits in the Limited Liability Company Law,” and even though the Legislature considered, but rejected, including a derivative right of action in the LLC Law.
Another remedy not found in the LLC statutes is the so-called “equitable buyout” in LLC dissolution proceedings.
In a nutshell, an equitable buyout grants an LLC member the possibility upon dissolution of the company (under circumstances yet to be well defined by the courts) of the ability to purchase the other member’s interest as an alternative to liquidation and sale of the company’s assets at auction. An equitable buyout results in one member involuntarily selling his or her equity to the other, and the other member becoming the business’s sole owner. The entity’s existence continues post-buyout – despite ostensibly being “dissolved.”
Context in the LLC Law and Elsewhere
Three principles made the phenomenon of LLC equitable buyouts potentially improbable.
First, the LLC Law does not authorize a buyout in dissolution proceedings, as the courts noted in Lyons v Salamone, 32 AD3d 757 [1st Dept 2006], and Matter of Superior Vending, LLC, 71 AD3d 1153 [2d Dept 2010].
Second, “LLCs are ‘creatures of contract.’” LNYC Loft, LLC v Hudson Opportunity Fund I, LLC, 154 AD3d 109 [1st Dept 2017]. Where members of an LLC did not bargain for buyout rights in an operating agreement, courts arguably ought not supply such rights based upon notions of equity.
Third, outside of the LLC Law, a court-ordered buyout in judicial dissolutions is confined to two narrow areas, both in corporate dissolutions for “illegal, fraudulent or oppressive” conduct under Section 1104-a of the Business Corporation Law (“BCL”):
- Under BCL § 1118, the majority may elect up to 90 days from the case’s commencement to purchase the petitioner’s shares for “fair value.”
- Under Matter of Kemp & Beatley, Inc., 64 NY2d 63 , courts are required to consider fashioning “some remedy short of or other than dissolution” – like a buyout – to satisfy the petitioner’s “expectation of a fair return on his or her investment.
Outside of BCL § 1104-a, “the only authorized disposition of corporate assets is liquidation at a public sale.” Ravitz v Furst, 65 AD3d 1049 [2d Dept 2009]. Why then – and perhaps more importantly, when – is a buyout permissible in an LLC dissolution proceeding? The evolution of the LLC equitable buyout doctrine provides insight.
Primordial Origins – Mutual Buyout Rights
The LLC equitable buyout came into existence like the Big Bang, seemingly from nothing, in an unpublished decision by Justice Betty Owen Stinson in Lyons v Salamone, Decision/Order, Index No. 24290/2004 [Sup Ct Bronx County Dec. 23, 2005].
In Lyons, Salamone contributed 80% and Lyons 20% of the capital for a gym, receiving proportional equity interests. The business lost money, the members’ relationship soured, and Lyons sued to dissolve. The Court held that the business was “failing financially,” granted dissolution, and appointed a receiver. Then – without any statutory or case law support – the court expressed a preference for “reorganization,” and gave both parties “the option of bidding” for the other’s interest in the LLC, with the highest bidder to get the company.
On appeal in Lyons, the First Department affirmed, holding that granting “mutual buyout rights” was an “equitable method of liquidation,” even though the 20% member, who sued for dissolution, opposed a mutual buyout. The term “liquidation” was a misnomer – the legal entity remained intact, and the business would continue as a going concern. Like the lower court, the Appellate Division cited no authority for its ruling. And just like that, a law was born.
Doctrinal Evolution – Unilateral Buyout Rights
The next evolutionary step came from Westchester County Commercial Division Justice Alan D. Scheinkman (recently appointed Presiding Justice of the Appellate Division, Second Department) in Tal v Superior Vending, LLC, 20 Misc 3d 1103 [A] [Sup Ct NY County June 6, 2008].
In Superior Vending, Plotkin solicited Tal to acquire 50% of an LLC that operated a vending machine business. Plotkin owned the remaining 50%. After a dispute, Tal withdrew from the business and ceased making required payments for the LLC’s debts. Tal sued for dissolution, but abandoned his case, resulting in dismissal.
In the meantime, Plotkin paid significant debts of the LLC, made additional capital contributions, and grew the business. Tal sued again for dissolution. At trial, the parties stipulated to dissolve. The Court, relying upon Lyons, and noting that the “whole of this company, like most companies, is worth more than the sum of its parts,” ordered that the “fairest and most equitable approach” was to “provide for a return to Tal of his membership contribution and then for a distribution based on his membership interest.” A softly-spoken forced buyout – much different than Lyons’ mutual buyout.
On appeal, the Second Department affirmed, relying upon Lyons, holding that the “most equitable method of liquidation” was for Plotkin to have the option to “purchase all of Tal’s right, title and interest in Superior.”
Apogee – Reversible Error Not to Order a Forced Buyout
Equitable buyout law took a giant leap forward in Mizrahi v Cohen, 104 AD3d 917 [2d Dept 2013]. Mizrahi and Cohen were 50% members of a real estate company. The operating agreement required unanimous consent for capital calls. The company continuously lost money. Mizrahi asked Cohen to contribute capital. Cohen refused. Mizrahi was forced to infuse hundreds of thousands of dollars of his own to stave off a mortgage default. As a kicker, Cohen surreptitiously “borrowed” $230,000 from the company for personal debts, which he did not repay, exacerbating the LLC’s insolvency.
In Mizrahi v Cohen, 34 Misc 3d 1210 [A] [Sup Ct Kings County Jan. 12, 2012], Kings County Commercial Division Justice Carolyn E. Demarest considered “avoiding the disastrous consequences of dissolution” with a buyout, but eventually rejected the idea because the members had an operating agreement that did not contemplate a buyout, and both members continued to be active business participants, unlike in Superior Vending.
The Second Department reversed, holding that “[u]nder the facts of this case,” the lower court “should have granted, in effect, the plaintiff’s application for an order authorizing him to purchase the defendant’s interest in the LLC upon its dissolution.” Mizrahi suddenly altered equitable buyouts from a remedy the court sometimes may order, to one the court sometimes must order.
Ironically, while the appeal was pending, Justice Demarest issued a second decision, Mizrahi v Cohen, 38 Misc 3d 1213 [A] [Sup Ct Kings County Jan. 15, 2013], changing her mind based upon accounting and appraisal reports that an auction would result in total loss of both members’ equity, and granting the parties mutual buyout rights. But according to the Second Department’s holding in Mizrahi two months later, even that would not have been enough – only a forced, unilateral buyout was appropriate.
Doctrinal Limit – Petitioner Must Have a Viable Dissolution Claim
The most recent appellate decision considering equitable buyouts, Kassab v Kasab, 137 AD3d 1138 [2d Dept 2016], set a basic threshold requirement – “there is no basis to invoke the equitable remedy of a buyout” unless the petitioner can “state a cause of action for the judicial dissolution of the LLC pursuant to Limited Liability Company Law § 702.”
What are key common features of the appellate-level cases in which courts awarded equitable buyouts?
- Each involved LLCs with just two members.
- Each involved a substantially disproportionate investment, either in capital contributions, loans, or managerial effort, by one member, which made it “equitable” to buy out the other.
- A significant outlier fact in Mizrahi, which seems to have driven the Appellate Division’s decision to require a buyout, was financial defalcation by the bought-out member.
Despite a solid judicial foothold, some questions about LLC equitable buyouts remain.
How will the Court of Appeals, if one day presented with the question, view the doctrine in light of the contractual rubric of the LLC Law? Tzolis v Wolff indicates that the Court is not necessarily opposed to finding new common-law remedies for LLCs so long as not expressly prohibited by statute.
Will courts eventually “borrow” the LLC equitable buyout concept for other kinds of dissolution proceedings? At least one court, Cortes v 3A N. Park Ave Rest Corp., 46 Misc 3d 670 [Sup Ct Kings County Oct. 28, 2014], cited to Mizrahi v Cohen as authority for ordering a buyout in a common-law corporate dissolution proceeding. Though to be fair, the court in Cortes relied primarily on BCL 1118 and Matter of Kemp & Beatley as authority for a discretionary buyout remedy following an order of dissolution.
Finally, might a forced buyout concept based upon notions of equity eventually percolate into corporate dissolution proceedings based on deadlock under BCL § 1104?
Time will tell.