Turmoil Follows Involuntary Transfers of LLC Membership Interests
April 20, 2020
LLC enabling legislation swept the country in the late 1980s through the mid 1990s. By the turn of the century we saw a trickle of litigation working its way through the courts involving disputes among LLC co-owners. A decade later, as the popularity of LLCs blossomed, the trickle became a steady stream. Fast forward to the present, when LLCs have thoroughly upstaged the closely held business corporation as the entity of choice, the stream has become a river.
Within what has become a vast body of case law over the last two decades stemming from LLC internal disputes, I see two fields of member conflict that not only quantitatively occupy large swaths of that body, but also qualitatively distinguish LLC litigation from its counterpart litigation involving disputes among shareholders of close corporations.
One is judicial dissolution. Although the Revised Uniform LLC Act adopted in many states has partially reduced the dissimilarity between grounds for judicial dissolution and available remedies compared to prevailing forms of corporate dissolution statutes, there remains in New York and many other states an unbridgeable, substantive gap between the dissolution standards and remedies in the two statutory schemes. As New York’s leading appellate decision on LLC dissolution opined ten years ago, “since the Legislature, in determining the criteria for dissolution of various business entities in New York, did not cross-reference such grounds from one type of entity to another, it would be inappropriate for this Court to import dissolution grounds from the Business Corporation Law or Partnership Law to the LLCL.”
The other is the validity and effect of membership interest transfers and other dispositions of membership interests. There are few if any statutory default rules constraining lifetime or post-mortem transfer of shares–with all their attendant voting, economic, and other rights–by a shareholder of a close corporation. Any constraints that do exist will be found in the shareholders’ agreement or by-laws and, even then, case precedent holds that any such limitations may not cross mandatory rules in the business corporation law and may not otherwise impose “unreasonable” restraints on alienation.
In contrast, the default rules found in LLC statutes embrace the pick-your-partner principle borrowed from partnership law, under which the right to transfer or otherwise dispose of a membership interest is subject to major restrictions that can be strengthened, diminished, or eliminated by the terms of an operating agreement. For instance, except as otherwise provided in the operating agreement:
- Section 603 of New York’s LLC Law provides that a membership interest is assignable in whole or in part and that the only effect of an assignment is to entitle the assignee to receive the distributions and profit and loss allocations to which the assignor would be entitled.
- Section 604 provides that an assignee may not become a member without the vote or written consent of at least a majority in interest of the other members.
- Section 606 bars a member from withdrawing from the LLC prior to its dissolution and winding up.
- Section 608 provides that upon the death of a member, the member’s estate’s representative may exercise all of the member’s rights “for the purpose of settling his or her estate.”
These and other provisions in the legislative scheme create an oft-devilish interplay between statutory default rules and LLC agreements, which in turn generates an ever-expanding corpus of decisional law adjudicating the validity and effect of membership interest dispositions. Most of the decisions deal with disputed voluntary assignments occurring either during a member’s lifetime or by testamentary disposition. The two decisions examined below are different. They involve involuntary transfers of LLC membership interests, one by automatic withdrawal upon filing a dissolution petition and the other by sale in bankruptcy. Voluntary or involuntary, the interplay between statute and contract plays an important role.
Statute’s Default Rules Leave Involuntarily Withdrawn Members With Economic Interest Only
Earlier this month, the Maryland Court of Special Appeals decided Donnelly v McNelis involving a dispute between 50/50 factions of a Maryland LLC formed in 2005 to acquire a specific parcel of commercial realty. Both the real estate market and the relationship between the two factions soured after 2008, eventually leading to a default under the Deed of Trust securing the mortgage loan.
Meanwhile, Faction #1 discovered potential commercial pier rights associated with the property and, after Faction #2 expressed disinterest in pursuing them, in 2012 Faction #1 purported to enter into an Assignment of Pier Rights by the LLC to one of the two members of Faction #1 for consideration in the amount of $10. The assignment also included the assignee’s agreement to hold the pier rights in trust for the members of the LLC individually and to divide the net proceeds from any recovery to each member in equal shares. Faction #1 did not disclose the assignment at the time to Faction #2, which learned of it by searching land records a year later.
Multiple lawsuits between the two factions were filed before and after Faction #2’s discovery of the assignment. One of the lawsuits brought by Faction #1 sought dissolution of the LLC and appointment of a receiver. Faction #2 filed suit seeking, among other claims and remedies, a declaration that the Assignment of Pier Rights was invalid and that the two members of Faction #1 involuntarily withdrew from the LLC, and thereby lost their voting rights, under a provision in the operating agreement defining “Involuntary Withdrawal” trigger events to include the filing of a petition seeking dissolution or appointment of a receiver.
The trial judge ruled for Faction #2 on their claim to invalidate the Assignment of Pier Rights but denied their request to declare that the members of Faction #1 lost their voting rights. Both sides appealed.
In its opinion last month, the appellate court held that the assignment was void ab initio because it was executed only by the two members of Faction #1 holding an aggregate 50% interest, i.e., without authorization by a majority in interest of the members as required by the LLC’s operating agreement.
On the issue of voting rights, the appellate court agreed with the trial judge that, applying the operating agreement’s clearly expressed definition of “Involuntary Withdrawal,” the members of Faction #1 had involuntarily withdrawn from the LLC by filing a dissolution petition. However, the appellate court disagreed with the trial judge with respect to their retention of voting rights, holding that their withdrawal and status as former members likewise terminated their voting rights in the LLC. In addition, the withdrawal of Faction #1 did not trigger dissolution under an express provision in the operating agreement continuing the LLC’s existence upon member withdrawal unless the company had no other members for 90 days post-withdrawal, which was not the case.
But as the court went on to observe, the operating agreement “does not provide what happens to the withdrawn member’s interest.” The court therefore looked to the applicable statutory default rules for guidance. Under section 4A-606.1(a) of Maryland’s LLC Act:
[W]ithin a reasonable time after the person ceased to be a member, the limited liability company may elect to pay the person or the person’s successor in interest, in complete liquidation of the person’s membership interest, the fair value of the person’s economic interest in the limited liability company as of the date the person ceased to be a member, based upon the person’s right to share in distributions from the limited liability company.
Notice that the statute speaks permissively (the LLC “may elect to pay”). If the LLC chooses not to liquidate the individual’s membership interest, under subsection (b) of the statute, “that person will be deemed to be an assignee of the unredeemed economic interest.” Since the company did not elect to liquidate their interests, the court concluded, the Faction #1 members “have ceased to be members of [the LLC] and, therefore, only have a remaining economic interest in the LLC.”
An astute member or its counsel, armed with knowledge of the statute’s default rules, and especially given the 50/50 line-up of the two factions, likely would have eliminated the provision for automatic withdrawal upon filing a dissolution petition or, alternatively, would have paired the provision with a mandatory buy-sell of some sort. Unfortunately for Faction #1, they now find themselves cast out of the LLC as non-members, with no voting or management rights, no standing to sue derivatively, and unable to demand access to books and records or seek judicial dissolution. All they can hope for is a share of distributions as, if, and when made at the whim and under the sole control of the Faction #2 members.
Bankruptcy Sale of Third Member’s Interest Leaves Remaining Two Members’ Ownership Percentages in Limbo
A decision last month by the Brooklyn-based Appellate Division, Second Department, in Ghatani v AGH Realty, LLC, involved an appeal from the trial court’s judgment declaring that Member #1 and Member #2 held 58% and 42% interests, respectively, in an LLC formed out of a joint venture to acquire and develop two vacant lots in Brooklyn. Originally the LLC had three members with equal one-third membership interests and equal sharing of profits and losses. Members #1 and #2 each made a capital contribution of $340,000 while Member #3 contributed only $130,000 allegedly in consideration of his acting as the project’s general contractor.
In 2010, Member #1 sued the other members in Nassau County Supreme Court to recover damages for breach of fiduciary duties, dissolution of the LLC, and an accounting. While the action was pending Member #3 filed for Chapter 7 bankruptcy. The bankruptcy trustee moved for an order approving the sale of Member #3’s interest in the LLC. Member #1 filed an objection asserting that Member #3 held only a 16% interest in the LLC given his smaller capital contribution to the LLC in relation to the other two members. The bankruptcy court denied the objection and approved the sale of Member #3’s interest to Member #1 for $32,000.
Member #2 subsequently filed a motion in the Supreme Court action for a judgment declaring that he held a 50% interest in the LLC rather than a one-third interest as contended by Member #1. In its initial ruling, citing a provision in the operating agreement that no member shall transfer his interest except to one of the other members, the court declared Member #2 a 50% member on the ground that Member #3’s membership interest was a “corporate opportunity” and that Member #1 therefore is deemed to have “acquired it from the bankruptcy trustee on behalf of the [LLC].”
In its ruling on Member #1’s subsequent motion to reargue, however, the court reversed itself and held that the bankruptcy sale of Member #3’s interest was not a corporate opportunity because, at the time, Members #1 and #2 already were litigating against each other and therefore Member #1 owed Member #2 no fiduciary duties. But neither did the court endorse Member #1’s claim to hold a two-thirds interest, instead finding that he held only a 58% interest based on the “inconsistent” objection he asserted in the Chapter 7 proceeding that Member #3 held only a 16% membership interest because of his smaller capital contribution.
Member #1 appealed, arguing that he was not judicially estopped by his objection because the bankruptcy court had rejected it. The appellate panel agreed, writing:
For the doctrine [of judicial estoppel] to apply, there must be a final determination endorsing the party’s inconsistent position in the prior proceeding. Here, there has been no judicial determination, final or otherwise, endorsing [Member #1’s] position in the Bankruptcy Court regarding [Member #3’s] interest in relation to the interests of the other shareholders [sic]. [Citation omitted.]
Noting that “the parties’ respective interests in [the LLC] have yet to be determined,” the court remanded the case to the lower court for further proceedings with respect to Member #1’s claims for damages, dissolution, and an accounting.
Ghatani leaves unspoken whether, under the operating agreement or the terms of the bankruptcy sale, the interest of Member #3 sold to Member #1 conveyed all voting, management, and economic rights held by Member #3, or just economic rights as would occur under the statutory default rule absent the consent of Member #2.