Over its three-decade rise to the closely-held business entity of choice, the Limited Liability Company has won a special place in our hearts. The majority of disputes we litigate and blog about concern ownership of or governance in an LLC. So as Business Divorce lawyers and bloggers, we are duty-bound to stay abreast of changes and trends in the LLC legal landscape. That’s where the Business Law Section of the American Bar Association’s annual LLC Institute comes in. The two-day conference hosts the nation’s leading authorities for deeply insightful discussions on legal developments concerning LLC formation, governance, and use.
For those interested in learning the intricacies of the LLC laws directly from the experts, I highly recommend attending the Institute. At the 2023 LLC Institute recently held in Denver, CO, Peter Mahler and I had the pleasure of sharing our views from the Business Divorce trenches on emerging trends or potential trends in LLC litigation. Here is a recap of the lively panel discussion, Frontiers of LLC Member Litigation: Sex Discrimination as Oppression, Freeze-Out Mergers, and Direct vs. Derivative Claims.
Sex Discrimination as Oppression
Guided by Professor Meredith R. Miller of Touro Law, the Panel first explored how the recent “Me Too” movement has made its way into disputes among owners of closely-held businesses.
Professor Miller told the story of Diane Straka (her case summarized in this post), a 25% shareholder of an accounting firm organized as a professional corporation. Notwithstanding her decades of experience and substantial contributions to the firm, Straka faced sexual harassment from a senior accountant, which the majority shareholders failed to address.
Professor Miller explained that had Ms. Straka consulted an employment lawyer about her dilemma, she might have left that consultation dissatisfied. That is because the traditional means for addressing sex discrimination in the workplace—Title VII—protects employees, but arguably not business owners.
Instead, Straka petitioned for dissolution of the firm on the grounds of minority shareholder oppression under BCL 1104-a.
After a hearing, Erie County Supreme Court Justice Henry J. Nowak found that the majority shareholders oppressed Straka under BCL 1104-a by, among other misconduct, failing to address the senior accountant’s inappropriate, discriminatory behavior:
This court finds that [the respondent majority shareholders], and indeed, any shareholder of any corporation, should know that a female shareholder reasonably expects to be treated with equal dignity and respect as male shareholders forming the majority. Straka has demonstrated that she was not. The shareholders’ slow and inadequate response to [the senior accountant’s] demeaning behavior marginalized Straka, as did the lack of respect provided to her as the head of IT at the corporation.
In jurisdictions where minority LLC Members have a cause of action for majority oppression, Miller posited that the oppression remedy could help fill some of the gaps that Title VII leaves with respect to LLC members as owners, but not necessarily employees. Consider the case of Bare v AL. Ringling Brewing Co., No. 3:21-cv-00642-jdp (WD WI 2021), in which a shareholder sought oppression-based dissolution of a brewery based on the majority’s sexual harassment of his wife. Do Straka and Bare maketh a trend?
Prompted by comments from Connecticut attorney and RULLCA expert David Levine, the Panel discussed the potency and adequacy of the minority owner oppression claim as a remedy for sex discrimination. Is dissolution too drastic a remedy? What alternative remedies might a court consider in the case of an oppression claim based upon sex discrimination? These questions presumably will be litigated if creative LLC members use the oppression remedy as a means to address sex-based (or other) discrimination.
Freeze-Out Mergers
Regular readers of this blog surely saw this topic coming. The Farrell Fritz Business Divorce team has been on the forefront of the explosion in popularity of freeze-out mergers in New York LLCs (as catalogued here), and the Panel eagerly shared the circumstances of that explosion and the potential availability of freeze-out mergers in other jurisdictions.
The Panel discussed how freeze-out mergers can be effective, indirect expulsion devices in circumstances where: (i) there is no mechanism in the governing law or the operating agreement giving the LLC or the majority the right to expel a member, and (ii) the governing law and operating agreement do not require unanimous consent to approve the merger. Among other attributes, the freeze-out merger:
- Can be presented as a fait accompli. In jurisdictions where an LLC can act upon written consent in lieu of meeting, and where such written consent trumps any specific statutory notice requirement concerning merger, the freeze-out merger can happen before the frozen-out member even finds out about it, much less runs to court in an effort to enjoin it.
- Is effective immediately. Upon closing of the merger, the frozen-out member immediately ceases to own a membership interest in the active company, which immediately terminates the member’s standing to sue derivatively, petition for dissolution, or seek access to the company’s books and records.
But the true power of the freeze-out merger turns on whether the frozen-out member has the right to challenge the validity of the merger or otherwise seek its rescission. The Panel discussed the watershed New York case of Farro v Schochet (summarized in this post), which held that a frozen-out minority member’s sole recourse is to dissent from the merger and pursue an appraisal proceeding to determine the fair value of their interest, and that, to quote the Second Department, “no exception exists for alleged fraud or illegality in the procurement of the merger.”
The Panel then explored other jurisdictions. While Massachusetts has a statutory scheme similar to New York’s—including a provision stating that dissent and appraisal is the frozen-out members’ exclusive remedy—the State’s highest Court, in Allison v Eriksson, 98 NE3d 143, 146 (Mass. 2018) held that the Court may still “provid[e] the dissenting members with an equitable remedy other than the statutory right of distribution. . . .”
Other states fall somewhere between New York and Massachusetts on the “exclusive remedy” spectrum. Georgia, for example, provides that a frozen-out member can only challenge the merger for a procedural failure or “in an action to test whether the number of shares required to authorize or approve the reorganization have been legally voted in favor thereof.” Florida expressly allows a challenge on the ground that the merger was “[p]rocured as a result of fraud, a material misrepresentation, or an omission of a material fact.” In states that adopted without modification the Revised Uniform Limited Liability Company Act, unanimous consent of the LLC’s members is required to authorize a merger, so—absent some authority in the operating agreement—the freeze-out merger is not a viable expulsion device. In short, your mileage may vary.
Delaware corporate attorney Eric N. Feldman offered the draftsman’s perspective: the potential of a freeze-out merger should cause LLC members to closely consider not only the consent requirements for approval of a merger, but also the use of tag-along rights. Well-drafted tag along rights for minority members may protect them from being left behind in a freeze-out or strategic merger.
Direct vs. Derivative Claims, SLCs
Finally, the Panel drew on the Point / Counterpoint pair of articles by Donald J. Weidner and Daniel S. Kleinberger (summarized in this post) to discuss whether the distinction between direct and derivative claims has well served LLCs and their members.
On the one hand, as suggested by Dean Weidner, the direct/derivative distinction arguably imposes a too-high barrier to the minority member’s access to judicial remedies by, among other limitations, (i) inviting litigation over whether claims are direct or derivative and (ii) subjecting the derivative claims to the deferential standard of review over the decisions of special litigation committees (“SLCs”).
On the other hand, as argued by Professor Kleinberger, the direct/derivative distinction is a necessary consequence of regarding the LLC as a separate legal person. And who’s to say that the barriers to a minority member’s ability to sue his or her co-owners is a bad thing? The direct/derivative distinction and deference to the decisions of SLCs protects against meritless suits from problematic minority owners. Finally, in many states (although not New York), an LLC member not content to bring derivative claims may have access to the direct claim of minority member oppression.
Bob Keatinge, who publishes the leading treatise on LLCs co-authored by the late Larry Ribstein, discussed whether the cause of action for an accounting helped to solve the direct/derivative dilemma. He observed that while a claim for misappropriation of LLC assets would be derivative, the accounting claim—which requires those in control of the company to prepare detailed and supported schedules of income and expenses over a defined period, and account for all transactions—is a direct claim. New York litigators often don’t appreciate that nuance (see this post).
Peter Mahler summarized the debate as reflective of the different preferences of the “two worlds of LLCs”: (i) the few-owner, member-managed, small businesses and (ii) the large, capital-intensive, manager-managed LLCs with both active owners and passive investors. While the latter LLCs often have access to sophisticated legal advice capable of utilizing complex and comprehensive operating agreements, the former LLCs are just as likely to execute an off-the-shelf operating agreement as they are to have no operating agreement at all. Perhaps Dean Weidner’s views speak more pragmatically to the world of the smaller LLC, whereas Professor Kleinberger’s views speak more pragmatically to the world of the larger LLC.
Thank you to the attendees of the 2023 LLC Institute, Johnny Lyle for organizing the event, and those contributing to the discussions above. Time will tell whether these topics live up to their billing as “Frontiers” of LLC member litigation, but the interest and intellect on display at the 2023 LLC Institute makes certain that the future of the LLC is in good hands.
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