Minority members in New York limited liability companies (“LLCs”) often did not prevail in actions brought under section 702 of the New York LLC Law for judicial dissolution. One of the reasons was that the statute’s “not reasonably practicable” requirement for dissolution was interpreted by many courts to require a showing of the LLC’s failed purpose or financial failure. Oppression, fraud, and other overreaching conduct by the majority directed at the minority were not considered grounds for dissolution. Similarly, minority partners have often faced substantial obstacles in seeking to dissolve New York partnerships.
Over the last year, several New York courts have evaluated the rights of minority members seeking to dissolve a New York LLC and minority partners seeking to dissolve a partnership. Below, we will examine two of those cases.
Minority Partner’s Attempt to Dissolve a Partnership Backfires as New York’s Highest Court Approves Discount-Laden Valuation of Departing Partner’s Interest
In Congel v. Malfitano, 31 N.Y.3d 272 (2018), a minority partner engaged in a unilateral attempt to dissolve a commercial real estate partnership by written notice under Partnership Law §62. His majority co-partners immediately sued for damages resulting from an alleged wrongful dissolution under their partnership agreement, which provided that a voluntary dissolution could only be accomplished by a majority vote. The majority of partners ultimately prevailed on liability. A trial was held to determine the value of the wrongfully withdrawn partner’s interest under Partnership Law §69.
The trial court began its analysis with a stipulated value of the minority partner’s interest of $4.85 million, then deducted approximately $4 million in damages and discounts, including a 35% Discount for Lack of Marketability (“DLOM”). The majority partners sought an additional 66% Discount for Lack of Control (“DLOC”), but the trial court rejected their argument based on longstanding case law prohibiting the application of DLOC in fair-value proceedings under BCL §§623 and 1118.
On appeal, the Second Department ruled in favor of the majority partners, distinguishing the case law applying the “fair value” standard in the corporation context from the “fair market value” standard applicable to partnership interests under Partnership Law §69. The Appellate Division consequently discounted the minority partner’s interest by an additional 66% which resulted in a diminution of the value of his interest by hundreds of thousands of dollars. The court’s actions should serve as a cautionary tale to minority partners who attempt to cash out their interests by wrongfully dissolving a partnership when the remaining partners wish to continue the venture.
On appeal, the Court of Appeals affirmed and held that the prohibition of DLOC in fair-value proceedings under BCL §§623 and 1118 did not apply in the context of Partnership Law §69, which “does not contemplate a valuation of the entire business as if it were being sold on the open market, but rather a determination of the fair market value of the wrongfully dissolving partner’s interest as if that interest were being sold piecemeal and the rest of the business continuing as a going concern.”1 Such an interest, New York’s highest court held, “is worthless to anyone buying that interest alone.”2 The Court of Appeals, therefore, affirmed the Appellate Division’s application of 35% marketability, 66% minority, and 15% goodwill discounts, which collectively erased around 80% of the stipulated top-line valuation.
Even more notable than its use of multiple valuation discounts was the high court’s adoption of a contract-centric approach to the wrongful dissolution issue. The trial court and the Appellate Division had both held that the partnership was not at-will and that the minority partner had wrongfully sought to dissolve it under Partnership Law §62; the trial court’s reasoning was that the partnership agreement specified a “particular undertaking,” and the Appellate Division’s reasoning was that the agreement specified a “definite term.” The Court of Appeals came to the same conclusion but dispensed with the at-will analysis under the statute, determining instead that “Partnership Law §62 has no application here, because the parties to the agreement clearly specified under what terms [the partnership] could be properly dissolved, i.e., what would constitute a dissolution under the agreement and what would constitute a dissolution in contravention of it.”3
Instead of focusing, as did the lower courts, on whether the partnership met Partnership Law § 62 (1) (b)’s durational criteria of “definite term” or “particular undertaking,” the Court of Appeals decided the wrongfulness of the minority partner’s unilateral dissolution without recourse to the statute, and instead employed a purely contractual approach in affirming the lower courts’ finding of wrongful dissolution based on the partnership agreement’s “clear and unequivocal terms” providing the exclusive means by which the partnership could be dissolved.
This contract-centric approach to the question of wrongful dissolution offers a new mode of analysis and suggests new drafting solutions for transactional lawyers who opt to form partnerships under New York law.
LLC Dissolutions: A Path to Victory for Minority Members
LLC dissolutions involve a standard that differs sharply from the traditional standards of deadlock and oppression associated with corporations. Ever since the Second Department’s seminal 1545 Ocean Avenue decision in 2010, which expressly divorced LLC Law §702 from the law as it had developed under Business Corporation Law §§11044 and 1104-a, dissolution of an LLC has required the petitioning member of an LLC to show either that (1) management is unable or unwilling to promote the business to achieve its stated purpose, or (2) continuing the business is financially unfeasible.5
In Matter of D’Errico, Decision & Order, Index No. 610084/2016 (Sup Ct. Nassau County, Aug. 21, 2018), the Nassau County Commercial Division analyzed 1545 Ocean Avenue’s standard to find that the subject company had been relegated to a “puppet” company, and that its continued existence was therefore rendered meaningless by the majority members’ misconduct. Matter of D’Errico involved a company named Epic Gymnastics, LLC (Epic), which was formed to operate a local gymnastics and exercise facility. The parties never entered into an operating agreement for Epic, but testimony during the trial demonstrated that the purpose of the company was to “jointly operate a high-quality gymnastics facility” whose purpose later was expanded to include other exercise classes. Epic soon racked up debt, much of it personally incurred and guaranteed by one of the minority petitioners. The majority of respondents locked the petitioners out of the company’s facility and bank account and formed a related company called BeyondEpic in which petitioners had no ownership interest. BeyondEpic began collecting monies from Epic’s customers, depositing the funds into Epic’s account, and utilizing the facility from which the petitioners had been excluded.
Following a trial on the dissolution claim, in which the minority member had sued under §702, Nassau Commercial Division Justice Timothy S. Driscoll ordered dissolution, finding that “it appears that BeyondEpic has reduced Epic to a marionette to be manipulated at will by BeyondEpic,” and that it was, therefore “nihilistic for [Epic] to continue.” At the conclusion of his ruling, Justice Driscoll notes the Second Department’s endorsement of equitable buy-out in Mizrahi v. Cohen6 and invites the respondents to apply to the Court to buy out the petitioners’ interest in Epic.
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1 31 N.Y.3d 272 at 296.
3 Id. at 883.
4 New York’s Business Corporation Law (“BCL”) provides shareholders owning 50% or more of a corporation two paths to judicial dissolution: a) BCL § 1104 – deadlock at the board or shareholder level such that the corporation “cannot continue to function effectively, and no alternative exists but dissolution”; and b) BCL § 1104-a – where directors or those in control of the corporation have been guilty of illegal, fraudulent, or oppressive actions toward the complaining shareholder(s).
5 In re 1545 Ocean Ave., LLC, 72 A.D.3d 121 (2d Dept. 2010).
6 2013 NY Slip Op 02056 (2d Dept Mar. 27, 2013). In this case, Mizrahi and Cohen were 50% members of a real estate company whose operating agreement required unanimous consent for capital calls. Cohen repeatedly “borrowed” hundreds of thousands of dollars from the company for personal debts, which he did not repay, exacerbating the LLC’s insolvency. In its opinion, the Second Department altered equitable buyouts from a remedy the court sometimes may order to one the court sometimes must order.