Last week, the Manhattan-based Appellate Division, First Department, handed down one of the more intriguing decisions by a New York court I’ve seen in a long time involving a dispute between LLC members.
The central issue in the case, brought by an investor in a Delaware LLC against the LLC’s controller, is whether an oral agreement between two sophisticated entrepreneurs, in which the controller allegedly induced the investment by guaranteeing to cash out the plaintiff’s position under either of two scenarios, is barred by the generic merger clause in a subsequent amended operating agreement that the investor never signed.
The lower court granted the defendant’s pre-answer dismissal motion following which the plaintiff appealed. The Appellate Division last week in Behler v Tao (read here) affirmed the order below in a 3-2 decision featuring a majority opinion authored by Presiding Justice Sallie Manzanet-Daniels, applying what she labels “explicitly contractarian” Delaware LLC law “sometimes leading to harsh results,” and a dissenting opinion authored by Justice Ellen Gesmer exalting “basic principles of contract law and fundamental fairness.”
Background
The case was decided on a pre-answer dismissal motion, hence most of the facts you’ll read in the court’s decision and here are the plaintiff Behler’s version of the events as laid out in his complaint which you can read here.
The Oral Agreement. Behler and the defendant Tao were close friends and occasional business partners since 2004. In 2012, Tao solicited Behler to invest $3 million in a publicly traded company Tao controlled called Remark Holdings. Instead of investing directly in Remark, Tao proposed that Behler invest in a Delaware LLC called Digipac which Tao as sole member formed to hold shares in Remark.
The sticking point for Behler was the illiquidity of the proposed membership interest in Digipac as compared to the publicly traded Remark shares. Tao allegedly sealed the oral agreement (the “Exit Opportunity Agreement”) under which Behler agreed to invest $3 million in Digipac by guaranteeing that, if the price of Remark’s shares hit $50 per share — at the time of Behler’s initial investment the shares were trading at $1 — Tao would cause Digipac to sell its Remark shares and distribute the proceeds pro rata to Behler, and if the shares didn’t hit $50 within five years, Tao would cash out Behler’s interest in Digipac based on the then-value of Digipac’s Remark holdings.
Digipac’s Operating Agreement. At the time of the Exit Opportunity Agreement in 2012, Digipac had a bare bones, two page operating agreement (read here) naming Tao as its Sole Member and Manager. The operating agreement stated that it could be amended “only in a writing signed by the Sole Member.” The court record is silent whether Behler ever saw a copy of the 2012 operating agreement prior to the litigation.
Although not mentioned in Behler’s complaint, the court record reflects that in 2014, Tao unilaterally prepared and sent Behler a 29-page, unsigned Amended and Restated LLC Agreement of Digipac along with a Joinder Agreement and Subscription Agreement. The Amended LLC Agreement (read here) was set up for signature by Tao only as both Manager and Member. Behler never signed the Joinder Agreement or Subscription Agreement.
The Amended LLC Agreement’s provisions include:
- Section 1.25 defines “Member” as “any party to this Agreement owning a Membership Interest or any Person who otherwise acquires a Membership Interest and has executed the Joinder . . .”
- Section 6.9 prohibits Member withdrawal prior to dissolution and winding up.
- Section 8.1 with certain immaterial exceptions requires the Manager’s prior written consent, “which may be withheld or conditioned for any reason,” for a Member’s transfer of “all or any part of its membership Interest . . .”
- Section 13.2 contains a standard merger clause stating that the Amended LLC Agreement
constitutes the sole and entire agreement of the parties to this Agreement with respect to the subject matter contained herein and therein, and supersedes all prior and contemporaneous understandings, agreements, representations and warranties, both written and oral, with respect to such subject matter, including the Original [LLC} Agreement.
- Section 13.3 provides that the Amended LLC Agreement may only be amended upon the prior written approval of the Manager and Majority-in-Interest of the Members provided “an amendment or modification modifying the rights or obligation of any Member in a manner that is disproportionately adverse to such member relative to the rights of other Members shall be effective only with such Member’s consent.”
The Alleged Breach. Remark’s share price never approached $50 per share. At the five-year anniversary of Behler’s investment in 2017, Remark’s shares were trading at $9.15 per share which according to the Exit Opportunity Agreement entitled Behler to be bought out for about $11.6 million.
Behler and Tao held meetings in 2017 both before and after the five-year anniversary of the Exit Opportunity Agreement. At a meeting in January 2018, Behler confronted Tao about his failure to honor the Exit Opportunity Agreement. Tao allegedly acknowledged his breach but stated that he did not want to liquidate Digipac’s Remark shares.
The Lower Court’s Dismissal of Behler’s Complaint. In 2020, Behler brought suit for breach of contract and promissory estoppel against Tao only, i.e., not against Digipac. In June 2022, Manhattan Commercial Division Justice Andrew Borrok granted Tao’s pre-answer motion to dismiss the complaint (read here), holding that under Delaware LLC Act Section 18-101[9] (“A member or manager of a limited liability company or an assignee of a limited liability company interest is bound by the limited liability company agreement whether or not the member or manager or assignee executes the limited liability company agreement”) Behler was bound by the Amended LLC Agreement which “does not provide for an automatic exit option and the operating Agreement otherwise indicated that it superseded any prior or contemporaneous agreement.”
Justice Borrok also found that “the terms of the alleged oral agreement are unenforceable because they are indefinite and incapable of being enforced” and that the “promissory estoppel claim fails because Mr. Behler’s reliance on Mr. Tao’s alleged promise was unreasonable based on the lack of definite terms as to any purported guaranteed exit strategy.”
The Appellate Division’s Majority Opinion
The opening paragraph of Justice Manzanet-Daniel’s majority opinion frames the issue and summarizes the basis for its affirmance of Justice Borrok’s order:
On this appeal, we are asked to consider whether a parties’ oral side agreement to repurchase shares survived the subsequent amendment of the LLC agreement concerning the same subject matter, and whether the contesting party’s “acknowledgment” of the existence of the side agreement subsequent to the execution of the amended LLC agreement had any legal import. We hold that the oral side agreement did not survive the amendment of the LLC agreement, which contains a merger clause and has provisions at odds with the side agreement; and that any so-called acknowledgement of the oral side agreement did not work as an estoppel or otherwise alter the calculus. We therefore affirm the order appealed from.
The opinion then sets up and knocks down each of Behler’s arguments on appeal. As to Behler’s argument that Tao was not authorized to unilaterally amend the original LLC Agreement in 2014 because he no longer was “Sole Member” when he signed the Amended LLC Agreement, the majority held that because the original LLC Agreement defined “Sole Member” as Tao and “was not conditioned upon [Tao’s] status as the sole member of Digipac in fact,” Tao had authority to unilaterally enter Digipac into the Amended LLC Agreement without the consent of its other members.
The heart of Justice Manzanet-Daniel’s opinion comes next, in which she rejects Behler’s argument that the Amended LLC Agreement does not supersede the Exit Opportunity Agreement because it is not expressly referenced by the merger clause. The following lengthy quote from the opinion also highlights Delaware law’s rigorous contractarian a/k/a freedom-of- contract approach to all things LLC:
This argument is also unavailing. As demonstrated below, plaintiff’s investment constituted his acquiescence to the terms of Digipac’s LLC agreement and its subsequent amendment. Delaware’s stringent statutory regime and case law, though sometimes leading to harsh results, unambiguously advises prospective investors in a closely held LLC (especially one considering a multi-million-dollar investment) to scrutinize the existing LLC agreement and condition their investment upon the clear written delineation thereunder of (i) their rights regarding subsequent distributions, (ii) their rights pertaining to any prior agreement which they intend to integrate into the LLC agreement, and (iii) the survival of their contracted-for rights in the event of any future amendments to the LLC agreement. Plaintiff did not do so in this case and his investment is thus exclusively governed by the terms of the amended LLC agreement.
Delaware LLC law is “explicitly contractarian,” and courts enforce and construe LLC agreements as any other contract (In re Coinmint, LLC, 261 A3d 867, 890 [Del Ch 2021]). As a member of Digipac following his November 2012 investment, plaintiff was a party to, and bound by, the amended LLC agreement under Delaware law (see Del Code Ann title 6, § 18-101(9) [“[a] member or manager of a limited liability company or an assignee of a limited liability company interest is bound by the limited liability company agreement whether or not the member or manager or assignee executes the limited liability company agreement”]; see also Seaport Vil. Ltd. v Seaport Vil. Operating Co., LLC, 2014 WL 4782817, *2, 2014 Del Ch LEXIS 183, *4 [Del Ch Sept. 24, 2014, C.A. No. 8841-VCL] [stating that under § 18-101(9) a “LLC and its members are parties to and bound by the LLC agreement, regardless of whether they sign it” and applying rule]).
As a result of settled Delaware law, plaintiff is thus bound by the merger clause (see LCM Holdings GP, LLC v Imbert, 114 AD3d 406, 406 [1st Dept 2014][applying Delaware law and stating “[t]the parties’ rights vis-À-vis each other as members of a Delaware LLC are defined by the operating agreement”]).
Here, the merger clause explicitly states that the amended LLC agreement supersedes all prior written and oral agreements concerning the subject matter of the amended LLC agreement, which includes the transfer of membership interests, distributions among Digipac’s members and the rights, obligations, and interests of the members to each other and to Digipac. The amended LLC agreement clearly concerns the same subject matter as the exit opportunity agreement, which scheduled Digipac’s liquidation of plaintiff’s membership interest and distribution to plaintiff of the proceeds thereof. Because the amended LLC agreement and exit opportunity agreement both concern the liquidation and distribution of plaintiff’s interest in Digipac, the amended LLC agreement, by virtue of the merger clause, supersedes the exit opportunity agreement (see In re Coinmint, 261 AD3d at 897 [noting in the context of an LLC agreement that a merger clause “proscribe[s] the Court’s consideration of all oral and written communications and agreements that occurred prior to the [LLC] agreement”]; see also Levy Family Invs., LLC v Oars + Alps LLC, 2022 WL 245543, *10, 2022 Del Ch LEXIS 20, *23-24 [Jan. 27, 2022, C.A. No. 2021-0129-JRS][dismissing claim for breach of alleged oral agreement to substitute promissory note with convertible note where promissory note contained explicit merger clause and did not reference prior and/or contemporaneous oral contract]).
Next, the majority rejects Behler’s argument that Tao’s alleged acknowledgements in 2017 and 2018 of his obligations under the Exit Opportunity Agreement and his breach thereof overcome any impact of the merger clause or otherwise constitute an oral modification of the Amended LLC Agreement. As to the former, the opinion observes that “[t]he exit opportunity agreement was superseded, and [Tao’s] obligations thereunder extinguished, by the amended LLC agreement in 2014.” As to the latter, the opinion points to the Amended LLC Agreement’s provision requiring the Manager’s written consent for any amendment.
Finally, the majority opinion upholds the dismissal of Behler’s promissory estoppel claim, writing that under Delaware law promissory estoppel does not apply where a fully integrated, enforceable contract (i.e., the Amended LLC Agreement) governs the promise at issue.
The Dissent
Right off the bat, Justice Gesmer’s lengthy, strongly worded dissent sets a very different tone and takes a very different approach than the majority opinion in which she emphasizes equitable considerations, writing:
The fundamental issue in this case is whether a manager of an LLC may persuade a friend to invest in his LLC by orally promising the friend a guaranteed exit opportunity at a specific time and price, and then, with total impunity, amend the LLC’s operating agreement unilaterally, by, among other things, including a merger provision which he now contends nullifies their oral agreement, relieves him of all obligations under it, and deprives his friend of all legal remedies, even though nothing in the amended operating agreement is inconsistent with Tao’s obligations to perform under the oral agreement. As stated, it is clear that the answer must be no. Yet that is just the conduct that the motion court approved, and what the majority would have this Court do, in violation of basic principles of contract law and fundamental fairness.
The dissent’s legal analysis finds, contrary to Justice Borrok’s characterization, that the Exit Opportunity Agreement “has no fatal flaw or missing material term which would require this Court to find the term of this oral agreement indefinite,” further noting that “Behler’s buy out would be based on easily ascertainable benchmarks such as the closing price of Remark, a publicly traded company, on the date of the buy out.”
The dissent next challenges the majority’s central conclusion that the Amended LLC Agreement’s merger clause supersedes and extinguishes the Exit Opportunity Agreement, explaining as follows:
The exit opportunity agreement, as described in the complaint, is an agreement made solely between two friends to induce Behler to invest by providing that Tao would make it possible for him to cash out his investment under certain circumstances and by a date certain. The 2014 amended agreement involved different parties (Digipac, as well as Digipac members who were not parties to the exit opportunity agreement) and governs in general terms the rights, obligations, and interests of Digipac’s members to each other and to Digipac. Behler adequately pleads that it does not govern the separate, standalone agreement made between Behler and Tao which induced Behler to invest in Digipac. Absent the exit opportunity promised by Tao, Behler alleges he would not have invested in Digipac.
Justice Gesmer places importance on Behler’s effort to enforce the Exit Opportunity Agreement against Tao and not Digipac as vitiating the majority’s insistence that that agreement is inconsistent with the Amended LLC Agreement, writing:
I disagree with the majority that Tao’s performance of his obligations under the exit opportunity agreement would be inconsistent with the 2014 amended agreement. Notably, Behler has sued only Tao, in his individual capacity, to enforce the exit opportunity agreement. He seeks “an order of specific performance, directing [Tao] to purchase his Digipac shares for $11,610,201.10.” Digipac is not a party to this action, and Behler does not seek any relief from Digipac.
The dissent also opines that dismissal is inappropriate and a trial is required because:
- “the terms of each agreement and their relation to each other are, at the very least, subject to more than one reasonable interpretation”;
- “consideration of the law regarding waiver weighs against finding that the 2014 amended agreement extinguished the exit opportunity agreement”; and
- Tao’s acknowledgements in 2017 and 2018 “evidence Tao’s understanding at that time that the exit opportunity agreement remained an enforceable contract that was made solely between the two friends and was different in subject matter from, and thus not affected by, the 2014 amended agreement.”
Onward and Upward to the Court of Appeals?
If there’s any good news for Behler, it’s that with the Appellate Division’s 3-2 decision, he gets an express ticket to appeal as of right to the New York Court of Appeals, the state’s highest court. I, for one, would look forward to that very much given the very few cases the Court of Appeals has decided involving LLCs since the LLC Law’s enactment 30 years ago.
True, the case is governed by Delaware law, but the fact pattern in Behler and its underlying issues involving LLC agreements are not peculiar to any one state’s LLC jurisprudence. I would say the major difference if there is one as regards New York law is its omission of an analog to DLLCA Section 18-101(9) binding non-signatory LLC members to the LLC’s operating agreement.
Finally, I can’t help but wonder whether the outcome in Behler might have been different had Digipac been a New York LLC governed by New York law. Historically, for better or worse depending on one’s perspective, New York case law has allowed greater leeway for the fact-specific equities of each case rather than subscribing to what Justice Manzanet-Daniel’s opinion describes as Delaware’s “explicitly contractarian” and “stringent statutory regime and case law . . . sometimes leading to harsh results.”
P.S. Remark’s share’s reached a trading high of $42.80 per share in February 2021. Today, its shares trade at $0.31 per share.
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