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Pulling the Reins on LLC Management

Maintaining the Balance Between Judicial Activism and Predictability

By Mark F. Geraci
Lewis Johs Avallone Aviles, LLP
Islandia, New York

When given the right set of ingredients, New York Courts have concocted creative remedies to solve legal problems to address what might otherwise be considered statutory shortfalls.

Perhaps most notably is the Court of Appeals’ decision in Tzolis v Wolff, 10 NY3d 100 (N.Y. 2008) which held that LLC members could bring derivative suits on the LLC’s behalf, even though there are no provisions governing such suits in the Limited Liability Company Law. The Court even recognized that the legislature might have considered, but declined to include such a provision in the law. In the years following Tzolis, Courts have walked a fine line between following the letter of the law and making bold pronunciations of judicial activism, leaving some to wonder if the counter-majoritarian difficulty truly exists where matters of corporate and partnership law are concerned.

Subsequent courts have grappled with the LLC form, looking both to statutory construction, common law and common sense when handling matters of partnership and corporation management. In Najjar Group, LLC v. West 56th Hotel LLC, 110 A.D.3d 638 (1st Dep’t 2013), the Court refined the freedoms allowed in Tzolis holding it necessary for a plaintiff suing derivatively on behalf on an LLC to allege presuit demand or demand futility. In rendering its decision, the Court drew analogously from Section 626(c) of the Business Corporation Law, and from its prior decision in Segal v. Cooper, 49 A.D.3d 467 (1st Dep’t 2008). Segal, which was decided forty two days after Tzolis, noted that demand to initiate a lawsuit would have been futile in a matter involving unjust enrichment and potential fraud in which the majority of controlling members of the LLC were interested in the challenged transactions.

Approximately one year after Tzolis was decided, the Court in Gottlieb v. Northriver Trading Co. LLC, 58 A.D.3d 550 (1st Dep’t 2009), created as a matter of common law, the right of an LLC to seek equitable accounting, notwithstanding the lack of such provision in the Limited Liability Company Law. Carrying the banner for the Court of Appeals, the Court in Gottlieb reasoned that denying such a right based upon a lack of statutory foundation was “inconsistent with the reasoning in Tzolis. ” See, id., at 551.

Furthermore, drawing analogously from the precedent set in Tzolis, the Court in JMM Properties, LLC v. Erie Ins. Co., 2013 WL 149457 (N.D.N.Y. 2013), justified its decision to impute the criminal acts of a managing member to the LLC, noting that shortcomings in the Limited Liability Company Law do not prevent the Court from taking action at common law. In so doing, the Court also cited Weber v. King, 110 F.Supp.2d 124 (E.D.N.Y. 2000), which in many respects, could be considered a forerunner to Tzolis. In Weber, the Court noted that it was “peculiar” that the legislature did not provide for derivative actions for LLCs even though they are a hybrid of partnerships and corporations, both of which allow such actions.

So too has the right of “equitable buyout” been birthed from generalized notions of common law and equity in the wake of Tzolis. From humble beginnings, equitable buyouts for LLC’s went from  an equitable remedy that might be invoked as a matter of common law, to one that should be used in certain circumstances. In Mizrahi v Cohen, 104 AD3d 917 (2d Dept 2013) the Court held 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.” Notably, this matter involved severe abuse of the LLC form by one managing member which led the entity to the brink of insolvency.

However, it seems that more recent case law is pulling the reins on the Tzolis precedent and calling into question the boundaries of judicial activism in LLC governance and management. Regarding equitable buyouts, the Second Department in Kassab v Kasab, 137 AD3d 1138 (2d Dept 2016), held that “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.” Perhaps precedent is returning to the years before Tzolis in which Courts routinely held that the Limited Liability Company Law does not authorize buyout in dissolution proceedings. See, Lyons v Salamone, 32 AD3d 757 (1st Dept 2006).

In keeping with the trend of relying on texts of limitation, the Court in LNYC Loft, LLC v. Hudson Opportunity Funt I, LLC, 154 A.D.3d 109 (1st Dep’t 2017), held that a managing member of an LLC could not appoint an outside attorney to serve as a special litigation committee to determine the merits of an LLC member’s derivative claims on behalf of the LLC. Here, the Court noted that “LLCs are ‘creatures of contract’” and pointed to the operating agreement which did not delegate managerial authority to nonmembers or nonmanagers or otherwise provide for appointment of an outsider to serve as a special litigation committee.

We are thus presented with a mixed-bag of precedent with regard to the management and governance of LLCs as courts test the waters of judicial activism in the face of statutory silence. Perhaps a more comprehensive statute is necessary to allow for greater predictability in LLC matters, or perhaps the courts are best situated to make determinations on a case-by-case basis accounting for factors such as management abuse, unjust compensation and fraud. But is this case-by-case approach the best way to address these matters at the expense of predictability, or should these issues be codified in statute by those more accountable to the public? Then again, maybe this convoluted interplay between the legislature and the courts is the most optimal solution to achieve fairness and efficiency. As cases unfold, and complex issues are tackled by the courts, we might be in a better position to assess what must be done to balance common law doctrine and judicial activism with predictability and legislative priority.

The general information contained herein is intended for informational purposes only. It is not intended to be, and should not be construed as, legal advice or legal opinion on any specific facts or circumstances.

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