Too Little, Too Late: Court Sides with Ousted Member, but Denies Preliminary Injunction Undoing Termination
October 18, 2021
We often cover preliminary injunctions on the pages of this blog because they are a powerful tool in the business divorce litigator’s toolbox: they force court action early in the case, they can protect rights that are difficult to monetize, and they set the tone for the litigation going forward. Requests for preliminary injunctions generally come early in the case, and they seek to impress upon the court the need for immediate action in order to maintain the status quo.
When a closely-held business threatens to reorganize its ownership to the exclusion of one owner, courts are receptive to requests for preliminary injunctions enjoining the restructuring until the ownership dispute can be sorted out in litigation. See this court’s enjoining dilution of an LLC member’s interest, or this court’s enjoining a freeze-out merger cancelling an owner’s shares.
Both of these cases featured, to some degree, a race between the parties. The company notified the owner that the dilution or freeze-out would occur on a certain date, and the owner scrambled to request a preliminary injunction enjoining that action before that effective date. While it can seem trivial, that race is critical. Because a preliminary injunction is designed to maintain the status quo, courts are far more likely to enjoin action before it happens than undo it after the fact. That’s the tough lesson that an LLC member facing termination of his membership status learned in Costello v Molloy et al., 73 Misc 3d 1206(A) [Sup Ct 2021].
Curis and the Working Members
Curis Partners, LLC, founded in May 2015, is a provider of home healthcare services. At its inception, Curis had four members, all of whom signed a May 15, 2015, Operating Agreement: Molloy, Petersen, Stivala, and—the plaintiff in this action—Costello. Pursuant to that Operating Agreement, Costello and Molloy each received a 25.1% membership interest in Curis, and Petersen and Stivala each received a 24.9% interest.
Curis was a startup, and all four founding members understood that it would take significant contributions of time and effort to make Curis a successful company. So in addition to their membership interests, each member assumed different roles within the Company: Molloy was the Company’s CEO and Manager, Costello was the COO, Petersen was the CIO, and Stivala was the Chief Medical Officer.
After the Company’s founding, Molloy brought on a fifth member, Foster, by giving Foster a 10% membership interest in Curis that came exclusively from Molloy’s interest. Unlike the founding members, who were “working members,” Foster had no title and he was not expected to contribute to the Company on a day-to-day basis. Rather, Foster became a member because he had significant assets, which Molloy perceived was a valuable resource to a Company that may one day need working capital.
Curis became a successful Company, with the founding members taking six-figure distributions in 2018 and 2019. While the pandemic decimated the home healthcare industry, Curis survived, and it is now poised to resume its initial successes post-pandemic.
The Operating Agreement’s Termination Provision
The Operating Agreement vests Molloy, as Manager, with significant discretion in the management and operations of Curis. Molloy has discretion to make distributions (§ 5.2.2), appoint officers (§ 6.3.1), and bind the Company to all agreements (§ 6.1.2).
Section 11.3 of the Operating Agreement, titled “Incapacity and Termination of Employment,” provided that Molloy, as Manager, also had the right to terminate the employment, with or without cause, of any member, which triggered the terminated member’s obligation to sell its membership interest back to the Company for the balance in the member’s capital account:
Upon termination of employment (with or without cause) or Incapacity (a “Withdrawal Event”) of a Member (“Withdrawn Member”), the Withdrawn Member shall be deemed to offer for sale (the “Withdrawal Offer”) to the Company all of the Withdrawn Member’s Units whether owned of record or beneficially by the Withdrawn Member (the “Withdrawn Interest”) and the Company shall be deemed to accept the Withdrawal Offer. . . . In exchange for the Withdrawn Interest the Company shall pay to the Withdrawn Member or its representative . . . an amount equal to the outstanding balance in the Withdrawn Member’s Capital Account . . .
According to Molloy, this was a critical aspect of the Company’s organization, necessary to keep the startup flexible enough to expel members who were not contributing. Molloy specifically recalled that when signing the Operating Agreement, he “called this provision to the other members’ attention before they signed the document because he wanted them to be aware that, as Manager, he would have the right to expel a member and the only recourse would be the return of the expelled member’s capital contribution.”
Curis Terminates Costello
On December 8, 2020, Molloy sent Costello a letter purporting to terminate him from his position at Curis and advising him that, per section 11.3, the Company would redeem his membership interest and pay him the balance of his capital account. The termination letter advised:
This notice of termination and release from Curis Partners LLC will be effective December 31, 2020 (“Effective Date”). . . . Pursuant to the terms of the Operating Agreement dated May 15, 2015 and amended November 10, 2015 (“Agreement”), you will be paid the outstanding balance of your Capital Account as of December 31, 2020 no later than February 15, 2021. . . .
Molloy contended that Costello’s termination was required because Costello had completely “checked out.” Costello stopped coming to the office and did no work for the Company between March and September of 2020, and Curis had to hire another employee to do Costello’s work.
According to Costello, he had always worked mostly from home; it was not until September 2020 that Molloy took issue with it. By that time, Molloy had already put Costello on the sidelines by transferring Costello’s work to a new employee. Costello insisted that Molloy sidelined him after Costello attempted to have Stivala and Petersen join forces with him to have Molloy removed as Manager.
Costello Belatedly Sues to Enjoin Cancellation of His Membership
Despite receiving notice on December 8 that the Company would redeem his interest effective December 31, 2020, Costello did not seek judicial intervention halting that action.
On January 1, 2021, viewing Costello’s membership interest divested as of December 31, 2020 based on the December 8, 2020, termination letter, the remaining Curis members entered into a Second Amendment to the Operating Agreement wherein Costello was “removed as a Member pursuant to 6.3.1 of the Agreement.” Costello’s 25.1% membership interest was divvied up among the remaining members.
Thereafter, on February 17, 2021, Costello commenced suit. Among other relief, he sought a preliminary injunction restoring him as a fully vested 25.1% member. In March, Westchester County Commercial Division Justice Gretchen Walsh granted Costello a temporary restraining order preventing the Company from “passing any amendment or other resolution that diminishes or otherwise adversely affects Costello’s rights on interest in Curis.”
Costello hinged his demand for reinstatement on the argument that the provision of the Operating Agreement pursuant to which he was supposedly removed, section 11.3, was inapplicable to him because he was a working member, not an employee: “Section 11.3 of the Operating Agreement expressly states and without qualification: ‘Upon termination of employment . . . of a Member . . .’ However, Plaintiff has never been an employee, nor a party to any employment agreement or arrangement with Curis LLC.” Because he was not an employee, Costello argued, he was not required to sell his interest under section 11.3.
Too Little, Too Late
After a two-day preliminary injunction hearing this summer, Justice Walsh issued last month her opinion in which, on the issue of whether section 11.3 applies to Costello, she mostly sided with Costello: “The evidence at the hearing makes clear that Costello was not an employee of Curis; instead, he was providing services as a working member of Curis.” She observed that the defendants’ interpretation of section 11.3—that it applies to all members, not just “employees”—was difficult to square with the remainder of the agreement and the reality of the parties’ arrangement. For one, applying section 11.3 to working members would put Foster, who never worked for the Company and therefore could not be terminated, on higher ground than the other members.
Justice Walsh was also skeptical of Defendant’s contention that Costello was entitled to no payment for his interest because, at the time of the notice of termination, Costello’s capital account balance was negative. Justice Walsh scrutinized the calculation of Costello’s capital account, finding that the Company failed to make certain adjustments to book value as required by the Operating Agreement. Accordingly, said Justice Walsh, Costello was likely to succeed on the merits of his claim that the termination of his interest breached the Operating Agreement.
Despite finding that Costello was likely to succeed on the merits of his claims for breach of the Operating Agreement, Justice Walsh refused to grant an injunction reinstating Costello. Justice Walsh held:
Despite the fact that Plaintiff has established a likelihood of success on his claim that Defendants breached the Operating Agreement based on their attempt to terminate Plaintiff’s membership and force a buy-out for no consideration, Plaintiff failed to meet his burden to obtain a mandatory injunction in which his membership interest and all of its attendant rights should be reinstated immediately. As stated previously, a mandatory injunction is an extraordinary and drastic remedy that should only be granted where such relief is essential to maintain the status quo pending trial. . .
So, because Costello’s membership interest in the Company had already been extinguished as of December 31, 2020, Costello’s request for a preliminary injunction was too little, too late. Likelihood of success notwithstanding, Justice Walsh held to the precept that injunctive relief should be prospective to maintain the status quo, not to operate on acts already performed.
Justice Walsh’s opinion leaves the parties in a curious position going forward. Molloy and Curis successfully defended Costello’s bid for a preliminary injunction reinstating him as a member. But they now have to contend with Justice Walsh’s ruling that Costello had established a likelihood of success on the merits that his ouster was a breach of the Operating Agreement. Costello, presumably, will move for summary judgment citing the same facts that the Court relied upon in its preliminary injunction decision.
It seems more probable than not that, had Costello moved for a temporary restraining order and preliminary injunction staying the cancellation of his membership interest prior to the effective date of December 31, 2020, the Court would have enjoined the sale of his interest and he would still be a member of the Company. And so Costello v Molloy is a poignant reminder that courts will be more inclined to preserve the status quo with a preliminary injunction than to undo action with one. Or, as Curis’ staff might advise their patients: an ounce of prevention is worth a pound of cure.