Llc Breakups And Judicial Dissolution: The Hurdles Are High

• Posted on: Mar 3 2017

Over the past few weeks, this Blog has explored the advantages and disadvantages of forming a limited liability company (“LLC”), as well as the fiduciary obligations of non-managing members in manager-managed LLC to each other and the LLC itself (here and here). In today’s installment, this Blog will explore the circumstances under which a member in a multi-member LLC can obtain a judicial dissolution of the company.

The Law Governing the Dissolution of an LLC  

An LLC is a hybrid business entity that provides the limited liability features of a standard corporation and the tax efficiencies and operational flexibility of a sole proprietorship or partnership. The “owners” of an LLC are referred to as “members.” An LLC can consist of a single individual, two or more individuals, corporations or other LLCs. In New York, LLCs are governed by the Limited Liability Company Law (“LLCL”).

There are two fundamental principles underlying the LLCL: (1) members can structure and operate the company as they see fit through the LLC’s articles of incorporation and operating agreement; and (2) unless the operating agreement provides otherwise, members wishing to dissolve the company can avail themselves of the LLCL’s dissolution procedures.

Article 7 of the LLCL governs dissolution of an LLC. Under Section 701(a), an LLC will be dissolved and its affairs wound up upon the first to occur of the following: a) the latest date provided in the articles of organization or the operating agreement; if no date is specified, then the existence of the LLC is perpetual; b) the happening of events specified in the operating agreement; c) the vote or written consent of at least a majority in interest of the members (subject to the provisions in the operating agreement); d) at any time there are no members in the LLC, unless a legal representative of the last remaining member agrees in writing within 180 days to continue the LLC and to the admission of the legal representative as a member; and e) the entry of a decree of judicial dissolution pursuant to LLCL §702.  Section 702 applies only when the articles of incorporation and/or the operating agreement do not provide the circumstances under which the LLC will be dissolved.

Section 702 of the LLCL empowers a court to dissolve an LLC “whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement.” The LLCL does not define the term “not reasonably practicable.”

Judicial dissolution under Section 702 is a drastic remedy. E.g., In The Matter of Dissolution of 1545 Ocean Ave., LLC, 72 A.D.3d 121, 131 (2d Dept. 2010). For this reason, New York courts strictly apply the standard set by Section 702. Matter of Horning v. Horning Constr., LLC, 12 Misc. 3d 402, 413 (Sup. Ct. Monroe Co., 2006).  As the Horning court observed: “Where the evidence does not demonstrate that it is not reasonably practicable to carry on the business in the circumstances (Limited Liability Company Law § 702), the court’s discretion, conferred by statute only, is not invoked and the petition must be dismissed.” Id. at 411 (footnote omitted).

In considering dissolution, LLCL § 702 requires the court to first examine the company’s operating agreement to determine whether it is not “reasonably practicable” for the company to continue to carry on its business in conformity with the operating agreement. 1545 Ocean Ave., LLC, 72 A.D.3d at 128. Where the operating agreement does not address the issue of member withdrawal or dissolution, the petitioning member is bound by the requirements set forth in the LLCL § 702. 1545 Ocean Ave., LLC, 72 A.D.3d at 128.

To satisfy the “not reasonably practicable” standard of Section 702, New York courts have required the member seeking dissolution to establish that: (1) the management of the entity is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved, or (2) continuing the entity is financially unfeasible. E.g., 1545 Ocean Ave., LLC, 72 A.D.3d at 131.

Common Reasons for Seeking Judicial Dissolution

The reasons advanced by petitioners wanting to dissolve an LLC are limitless. Some reasons fit comfortably in the standard set by Section 702 of the LLCL, while others do not. Regardless of the reason advanced, as noted, the petitioner must satisfy the “not reasonably practicable” standard.

Below are some of the more common reasons advanced by petitioners to dissolve an LLC.

Frustrated Purpose. A member may petition for dissolution because the stated purpose of the LLC can no longer be fulfilled. For example, the stated purpose of an LLC may be frustrated if the company was formed to market and sell light fixtures to a particular company and it loses its operative asset – the sales and marketing agreement with that entity. Similarly, the stated purpose of an LLC may be frustrated if the company was formed to develop and market technology that has become obsolete.

Member Breach. A member may petition for dissolution because of a breach of the operating agreement by another member, or because the other member has failed to perform as expected and has not lived up to the benefit of the bargain made by the members.

Discord and Dissention. Internal discord and dissention is generally the most common reason for LLC members to seek judicial dissolution.  For example, a member may petition for dissolution because the members cannot agree on the LLC’s strategy and current operations, or on the terms and conditions for raising and using operating capital. Importantly, discord and dissention between and among members is not by itself sufficient to warrant the exercise of judicial discretion to dissolve an LLC that operates in a manner within the contemplation of its purposes and objectives as defined in the articles of organization and/or operating agreement. See, e.g., Matter of Natanel v Cohen, 43 Misc 3d 1217(A), 2013 N.Y. Misc. LEXIS 2900 *12-13 (Sup. Ct. Kings Co. 2014). As discussed below, it is only where discord and dissention are shown to be inimical to achieving the purpose of the LLC will dissolution under the “not reasonably practicable” standard be considered by the court to be an available remedy to the petitioner.

Abandoned Business. A member may petition for dissolution of the LLC because the other members abandoned the business or the company has stopped conducting the business stated in the operating agreement.

Deadlock. A member may petition for dissolution of the LLC because the members are deadlocked in the management of the company’s affairs. In this regard, the deadlock is such that they are unable to break the impasse, and irreparable harm to the company is threatened or being suffered, e.g., the business and affairs of the company can no longer be conducted, or be conducted to the advantage of the company’s members because of the deadlock.

Member Misconduct. A member may petition for dissolution of the LLC because another member engaged in serious misconduct, mismanagement, illegality or fraud, or because a member owning a majority share of the company abused or exceeded his/her authority granted under the operating agreement.

A Case Study in Judicial Dissolution: Severe Discord Found To Satisfy The Standard of  LLCL § 702

On February 16, 2017, Justice Timothy J. Dufficy of the Supreme Court, Queens County, Commercial Division issued a decision concerning an application to dissolve an LLC under Section 702 of the LLCL. In In the Matter of The Dissolution of 47th Road LLC, a New York Limited Liability Company, 2017 NY Slip Op 50196(U), Justice Dufficy granted the application because the discord between the members was so severe, the LLC could not achieve its operating purpose.

Background

The case involved the application to dissolve 47th Road LLC, a New York limited liability company owned by two brothers, Vincent Cortazar and James Cortazar. Each brother had a 50% ownership interest in the company. The sole asset of 47th Road, LLC was a residential, four story walk-up apartment building with eight separate units occupied by tenants, having a fair market rental value of approximately $160,000 per year. The apartment building is located in Long Island City, New York.

In February 2011, the brothers borrowed $1,200,000 from Hudson Valley Bank (now Santander Bank) to purchase approximately one hundred acres in Rio Del, California. The loan was secured by a $1,200,000 mortgage on the Long Island City property. Unbeknown to Vincent, the California property was titled in his brother’s name only. When Vincent found out about the ownership of the property, he and his brother had “a physically violent confrontation.”

In addition to cutting Vincent out of the ownership of the California property, James locked his brother out of the company’s day-to-day operations, claiming that Vincent mismanaged the Long Island City property. With his brother out of the way, James collected the rents from the apartments, but did not pay down any of the indebtedness of the mortgage.

On March 1, 2016, the Santander mortgage loan matured. As a result, all amounts due under the note became due and payable. However, James refused to pay the mortgage. Consequently, the property went into foreclosure.

In addition to the foreclosure proceeding, there were numerous violations against the Long Island City property, amounting to over $33,000, as well as unpaid taxes, all of which jeopardized the economic feasibility of continuing the corporate existence of 47^th Road, LLC.

Finally, during the past few years, the brothers have asserted claims against each other in New York courts, as well as courts outside the state, seeking various forms of relief, including an application by Vincent to dissolve the company.

Court’s Ruling

The court granted the application to dissolve the company and appointed a receiver to wind down its business and operations.

As an initial matter, the court looked to the company’s operating agreement to see if there was any provision governing dissolution. Noting that the operating agreement only stated that the company’s business purpose was to operate an eight-unit residential apartment building in Queens County, N.Y., the court found that there was insufficient guidance on whether it was reasonably practicable for the company to continue to carry on its business operations. Given the broadly defined business purpose of the company, the court looked to the law under Section 702 of the LLCL.

As noted above, to successfully petition for the dissolution of an LLC under LLCL § 702, the petitioning member must demonstrate, the following: 1) the management of the entity is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved; or 2) continuing the entity is financially unfeasible. E.g., 1545 Ocean Ave., LLC, 72 A.D.3d at 131. The court found that Vincent satisfied this standard:

Disputes between members are alone not sufficient to warrant the exercise of judicial discretion to dissolve an LLC that is operates in a manner within the contemplation of it purposes and objectives as defined in its articles of organization and/or operating agreement. It is only where discord and disputes by and among the members are shown to be inimical to achieving the purpose of the LLC will dissolution under the “not reasonably practicable” standard imposed by LLCL § 702 be considered by the court to be an available remedy to the petitioner.

In the case at bar, the dissension among the parties has driven the company’s only asset into foreclosure. There are numerous outstanding violations on the property, and the respondent has collected the rents without making repairs, paying the violations, or the mortgage. There are other lawsuits in this and other states between the protagonists. Due to the violent relationship between the two managers, the company will be unable to achieve its purpose of operating an apartment building. The parties seem willing to permit the building to be foreclosed rather than cooperate with each other in the decision-making process. In short, the Court finds that it is not reasonably practicable to carry on the business.

Citations omitted.

Conclusion

Obtaining a judicial decree dissolving an LLC is not easy. 47th Road LLC shows how dysfunctional the relationship between members must be before the court will dissolve the company. Remember, in 47th Road LLC, the discord was so extreme, the brothers came to physical blows and allowed the company’s only asset to go into foreclosure. But, until that point, to the outside world, 47th Road LLC was a viable company –  a prior court declined to dissolve the company because of the inability to demonstrate financial unfeasibility.

Aside from highlighting the difficulties in obtaining a judicial dissolution under the LLCL, 47th Road LLC is instructive because it underscores the importance of negotiating and drafting an operating agreement that includes a provision governing how members can exit the LLC. While not every situation demands consideration of exit provisions at the outset of the company, the parties to the operating agreement should understand the consequences of that decision and the risk that they may not be able to agree on dissloution terms at a later date. As the preceding discussions show, reliance on the judicial dissolution provision in the LLCL may not be warranted considering the difficulties satisfying the standard required to obtain such relief.

Tagged with: Business Law, Business Litigation, Commercial Litigation