The Money’s There But Out of Reach for the Minority LLC Member
April 19, 2021
Of late I’ve been ruminating on New York’s membership in the shrinking pool of states that don’t recognize oppression of an LLC minority member by the controlling members or managers as ground for judicial dissolution.
The point indirectly was brought home by Professor Daniel Kleinberger’s recent article for the ABA’s Business Law Section in which he dissects last year’s decision by a Connecticut appellate panel in Manere v Collins interpreting that state’s Revised Uniform LLC Act which expressly includes oppression as one of the grounds for judicial dissolution. As the good professor highlights, the court’s decision freely borrows from the rich body of case law construing the term “oppression” as used in judicial dissolution statutes for closely held corporations in virtually every state save Delaware.
New York continues to buck the nationwide trend toward harmonization of close corporation and LLC law governing judicial dissolution, as made clear in cases such as Doyle v Icon and Barone v Sowers explicitly holding that New York’s LLC Law § 702 neither mentions nor otherwise accommodates oppression as a basis for seeking judicial dissolution.
Coincidentally, a case decided by the Manhattan-based Appellate Division, First Department, just a few days after Professor Kleinberger posted his article, starkly illustrates the disharmony of New York’s statutory schemes and the resulting disadvantageous position of a minority member of a New York LLC as compared to a minority shareholder of a New York close corporation when confronted with similar, allegedly oppressive behavior by the controlling co-owner.
Simon v Moskowitz
In Simon v Moskowitz, the Appellate Division affirmed in part and reversed in part a lower court’s order dismissing claims by a minority member against the majority member of a profitable, two-member LLC that owns a 60-unit, rental apartment building in the Bronx.
The complaint alleged that the controlling member cut off distributions on which the 82-year old plaintiff depended to supplement her retirement income. Meanwhile, the controller allegedly amassed a multi-million dollar cash reserve for no legitimate reason, including over a million dollars in excess funds from a refinanced mortgage done without plaintiff’s knowledge or consent; paid above-market management fees to its separate management company; and forced the plaintiff to pay taxes out-of-pocket on her pro rata share of allocated income — all for the alleged purpose of squeezing the plaintiff to sell her 18.75% interest to the 81.25% majority owner at a distressed price.
Were the realty-holding entity a close corporation rather than an LLC, such allegations would at least support a colorable, oppression-based claim for judicial dissolution under section 1104-a of the Business Corporation Law. But the subject entity being an LLC, plaintiff’s counsel apparently recognized that an oppression claim would not fly and that the alleged squeeze-out tactics would not satisfy New York’s relatively high bar for judicial dissolution of LLCs laid down in the 1545 Ocean Avenue case, requiring a showing either that the management of the entity is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved, or continuing the entity is financially unfeasible.
So instead, while characterizing the defendant’s actions as oppressive, the plaintiff’s complaint only asserted derivative and direct claims seeking damages and injunctive relief for breach of fiduciary duty and conversion, along with claims demanding access to books and records and for an accounting.
The Lower Court’s Dismissal of the Complaint
Following discovery the defendant moved for summary judgment based on provision in the operating agreement incorporating by reference and conferring on the manager the full panoply of authority granted LLCs under LLC Law § 202 including the rights to mortgage LLC property, to establish and maintain cash reserves, and to decide whether and when to make distributions. The defendant also relied on the absence of provision in the operating agreement requiring the manager to make distributions, as well as a provision eliminating manager liability for “any breach of duty” not involving intentional misconduct or knowing violation of law. The defendant also invoked the business judgment rule, arguing that the decision not to make distributions and to strengthen cash reserves for various contingencies was made in good faith and in the best interest of the LLC, and therefore was beyond judicial scrutiny.
The plaintiff argued in opposition that the defendant offered no evidence of needed repairs and improvements or any other legitimate reason for amassing over $2 million in cash reserves and withholding distributions while the company was realizing over $600,000 annual net income on its rental apartment building. Plaintiff submitted the affidavit of an expert witness with many years experience managing apartment buildings who, upon his review of the financial records, opined that there was no need to maintain cash reserves over $500,000 and that the balance of cash reserves should be distributed.
The lower court issued a Decision and Order dismissing the complaint in its entirety. The court found that the plaintiff failed to demonstrate that the defendant acted in bad faith or to show self-dealing or other misconduct by the defendant in breach of fiduciary duty. It also found that the defendant’s decisions not to make distributions, and not to deplete the cash reserves, was shielded by the business judgment rule. The court also dismissed the plaintiff’s claims to inspect books and records and for an accounting based on plaintiff’s failure to establish a breach of fiduciary duty.
The Appellate Division’s Decision
The Appellate Division’s decision made short work of the plaintiff’s appeal from the dismissal of her primary claims, writing:
The motion court properly found that plaintiff failed to present evidence that defendants acted in bad faith, engaged in fraud or self-dealing, wasted assets, or acted contrary to 2845 Associates’ legitimate purposes. The operating agreement provided Moskowitz with authority to determine when and if to make distributions, and the court will not second guess a decision protected by the business judgment rule.
However, the panel disagreed with the lower court’s dismissal of the claims for access to books and records and for an accounting based on plaintiff’s failure to plead breach of fiduciary duty:
[U]nder Limited Liability Company Law § 1102(b), plaintiff was entitled to certain specified financial records of 2845 Associates, which she contends were not provided to her. Moreover, as a member of 2845 Associates, Moskowitz owed plaintiff a fiduciary duty and she was not required to demonstrate that he breached that duty in order to obtain an accounting; the mere existence of a fiduciary relationship gives rise to a claim for an accounting. Moskowitz’s position as manager and principal of the management firm warranted an accounting and production of the specified records. [Citation omitted.]
The Unsurprising Lesson for LLC Minority Members
The Connecticut Court of Appeals in Manere observed that “a minority shareholder of a close corporation and a minority member of an LLC share many traits which make them vulnerable to oppression” — a point explored in much greater depth by Professor Douglas Moll in his article, Minority Oppression & The Limited Liability Company: Learning (Or Not) From Close Corporation History. Professor Kleinberger’s article on Manere perceptively adds,
Although LLC and corporate law differ in some fundamental ways, the dangers of oppression arise from a combination of business considerations and human nature. “Choice of entity” has little impact on these factors nor on the way in which they combine.
The path taken by the plaintiff in Simon v Moskowitz, culminating with her failed effort to compel distributions, began in not atypical fashion for closely held, realty-owning firms. The property initially was acquired in 1982 by a general partnership in which the plaintiff held a minority interest along with six others, no single one of whom held a controlling interest. As a general partner, Simon enjoyed adequate protections against overreach by any majority coalition by the Partnership Law and written partnership agreement. In 1997, the partnership converted to an LLC, at which time the former partners-now-members entered into what appears to be a one-size-fits-all, fill-in-the-blanks operating agreement offering little protection for minority members. Over time, the Moskowitz family bought out the membership interests of all the members except Simon, thereby removing any majority check on Moskowitz’s role as manager and leaving Simon as the sole minority member with no say in management, finances, or anything else under the operating agreement.
To be clear, I do not here suggest that Simon is the victim of majority abuse; the court found no fiduciary breach based on the terms of the operating agreement supported by the business judgment rule. On the other hand, one can appreciate the hardship on an elderly, outside investor in a profitable LLC who receives no distributions while having to pay taxes on her allocable share of the LLC’s substantial net income. Without a dissolution remedy for oppressive conduct, we’ll never know if Simon could have prevailed under the arguably friendlier reasonable-expectations standard.
Throughout the country LLCs have become the overwhelming choice of entity for newly formed firms. There is little if any prospect any time soon that New York will harmonize its LLC dissolution law with the statutory remedies available to oppressed minority shareholders of close corporations, as many other states have done.
Whether or not that ever happens, it is critical that anyone contemplating investing in an LLC, particularly as a non-managing minority member, pay maximum attention to, and engage competent counsel to assist with, thoroughly understanding and negotiating the terms of the LLC’s operating agreement to preserve robust rights to access company records, to assure to a reasonable degree that the LLC will distribute profits or at least enough to cover personal taxes on the LLC’s allocable, non-distributed net income, and to secure reasonable exit and assignment rights by way of testamentary disposition, buy-out or other lifetime transfer.