Mdde 604 Assignment 2 Operations

Assignment 2 - Case - Santa Cruz Guitar Company Santa Cruz Guitar Company (SCGC) is a small scale manufacturing operation, producing fewer than 800 instruments a year. The operations and quality practices reflect Deming's 14 points Create and publish a company mission statement and commit to it – SCGC manufactures handcrafted guitars which are monitored continuously during manufacturing process and assembly. Adopt the new philosophy- The manufacturing process is segmented to seven steps and the quality checks are done within those steps. Understand the purpose of inspection- The guitar will not go to the next step until the lead luthier is satisfied with the work done according to the SCGC standards. End business practices driven by price alone – In SCGC only the highest grades of tone wood are selected as raw materials. Constantly improve system of production and service- SCGC has a web page where guitar owners’ questions can be answered. Institute training

As Thomas Hoey, Jr., the formerly wealthy, self-proclaimed “Banana King,” sits in his prison cell serving lengthy sentences for beating up his mistress and for what the New York Post describes as “his callous attempt to cover up a wild coke orgy in a Manhattan hotel room that ended with one woman dead of an overdose,” and as he awaits sentencing for his subsequent conviction for stealing from the employee pension fund of his bankrupt, wholesale banana company, I suppose the least of his concerns is a civil court ruling last month throwing out his lawsuit seeking to enforce his assignment to his estranged wife of his membership interest in two real estate holding LLCs.

His loss is our gain, at least to those interested in the law governing transfer of LLC interests.

New York LLC Law § 603 sets forth the basic default rules governing assignment of LLC membership interests. Except as provided in the operating agreement:

  • membership interests are assignable in whole or in part;
  • assignment does not entitle the assignee to become a member or to exercise any membership voting or management rights; and
  • the assignment’s only effect is to entitle the assignee to receive distributions and allocations of profits and losses to which the assignor would be entitled.

Under LLC Law § 604 (a), except as provided in the operating agreement, an assignee can become a member only upon the consent of at least a majority in interest of the members excluding the assignor.

In Mr. Hoey’s case, in November 2013 he executed a one-page document oddly entitled Assignment of Stock and/or Propriety Interests, purporting to assign to his wife, Wendy Hoey, in consideration of the terms of a concurrent Separation Agreement, his ownership interests in certain realty along with:

his FIFTY (50%) percent interest in the LLC’s known as 1 SOUTH FOREST AVENUE, LLC, which owns the buildings known as 1 South Forrest Ave, Rockville Center, New York, and his FIFTY (50%) interest in T & H REALTY, LLC, which owns the buildings known as 156-158 Atlantic Ave, Lynbrook, New York 11563.

The other 50% membership interests in the two LLCs are held by Hilary Becker, who in November 2015 found herself on the receiving end of a lawsuit brought in the names of Thomas and Wendy Hoey asserting claims for partition of the real properties owned by the two LLCs, for an accounting, and declaring valid the November 2013 assignment (read complaint here).

The complaint refers to Thomas Hoey and Becker as the initial “sole joint owners of the properties” each with an “undivided 50% ownership interest,” and alleges that they acquired the properties “doing business as” the LLCs. It further alleges the assignment by Thomas to Wendy of his LLC “shares” and that, due to his incarceration and Wendy’s dire financial circumstances, they requested that Becker either buy them out or sell the properties which Becker refused to do. It also alleges that because the properties are part of the Hoey’s marital estate they “can be transferred/assigned” by Thomas to Wendy “as part of a separation/divorce without obtaining” Becker’s consent “[n]otwithstanding the fact that there is a partnership [sic] agreement which states that any sale and/or conveyance must be by unanimous consent.”

Becker responded with a motion to dismiss the complaint on the grounds, among others, that the Hoeys lack standing to seek a partition of the properties owned by the two LLCs; that the assignment by Thomas to Wendy is invalid under the anti-assignment provisions in Article 10 of the mirror-image operating agreements of the two companies governing transfer of membership interests; and, even assuming the assignment made Wendy the mere transferee of an economic interest, that as such she lacked standing to seek an accounting or to demand access to company records.

Becker’s argument cited several provisions in Article 10 of the operating agreements including:

  • Article 10.3 setting forth the prerequisites for transferring a membership interest and admitting a substitute member including obtaining the written consent of the other members “which consent may be arbitrarily withheld by any such Member”;
  • Article 10.6 providing that any attempted transfer of a membership interest “or any part thereof” not in compliance with Article 10 “shall be void ab initio and ineffectual and shall not bind the Company”; and
  • Article 10.4 providing that a non-member transferee “shall be entitled only to receive” the transferor’s economic interest in profits, losses and distributions and to receive pertinent year-end tax information, “and shall not have the rights of a Member of the Company . . . including the right to obtain information on account of the Company’s transactions, to inspect the Company’s books or to vote with the Members on, or to grant or withhold consents or approvals of, any matter.”

In opposition, the Hoeys’ counsel made no genuine effort to defend the efficacy of the assignment, and instead argued that even if the assignment was invalid, Thomas still retained his member’s right to an accounting and to the “dissolution” of the companies — a claim not pleaded in the complaint — and a partition of the properties.

The court’s decision last month by Nassau County Supreme Court Justice Robert A. Bruno (read here) granted Becker’s motion and dismissed the complaint. First, the court ruled that an LLC member cannot maintain in his individual capacity a cause of action for partition of realty owned by the LLC. Justice Bruno cited several case precedents to that effect and also quoted LLC Law § 601 providing that “[a] membership interest in the [LLC] is personal property” and that “[a] member has no interest in specific property of the [LLC].”

Second, Justice Bruno dismissed the Hoeys’s common-law accounting claim, not due to lack of standing as Becker argued, but based on the complaint’s failure to plead that, prior to bringing suit, the Hoeys made a “proper demand for an accounting” that was refused by Becker.

Third, Justice Bruno agreed with Becker that the purported assignment by Thomas to Wendy was invalid under Article 10.3 of the operating agreements prohibiting assignment without the other member’s consent. The absence of Becker’s consent, the judge held, conclusively established a defense as a matter of law, thereby mandating summary dismissal of the Hoeys’s claim seeking to enforce the assignment.

Some Additional Thoughts

  • Unlike the rules governing corporations, the “pick your partner” principle is given full force in LLC statutory and case law. Rare is the operating agreement that varies the statutory default rules prohibiting assignment of a membership interest without the consent of a majority in interest of the other members. Indeed, most operating agreements I’ve come across require the unanimous consent of the other members.
  • The Hoey case underscores the importance of including in the operating agreement a provision expressly declaring void any assignment that fails to comply with the operating agreement’s transfer restrictions. Compare and contrast the outcome in Hoey with the Shao case I wrote about almost three years ago, where the court held that, in the absence of such provision in the operating agreement, the sole available remedy for wrongful assignment is damages.
  • Less certain in Hoey was whether the assignment nonetheless effectuated a transfer to his wife of Thomas Hoey’s economic interest in the LLCs, an issue the court’s ruling did not reach. Article 10.2 of the operating agreement authorizes such transfers without the necessity of obtaining the other member’s consent, so long as the transferor assumes the LLC’s expenses relating to the transfer and provides a legal opinion that the transfer will not trigger certain adverse tax consequences. I saw no indication that Hoey complied with either of those preconditions. Had he done so, he might have been able to provide his wife with the economic benefit of any distributions generated by the realty operations and 50% of the net profits on any sale of the properties. (I offer this last bit of speculation not knowing whether there might be third parties including the government, victims of Hoey’s crimes, and other creditors who might have standing and grounds to set aside any such transfer.)
  • For the transferee of a bare economic interest, the obvious downside (beyond not having voting and management rights) is the absence of any member rights to inspect the LLC’s books and records, or to bring a derivative action against the managers, or to seek judicial dissolution. Arguably the remaining members come out ahead when that happens. When it comes to drafting the operating agreement, LLC members and their counsel must carefully weigh the pros and cons of allowing or prohibiting at-will transfers of economic rights.

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Update April 12, 2016:Professor Daniel Kleinberger, one of the foremost experts on LLCs and no stranger to readers of this blog (e.g. here and here), sent me the following comments inspired by the above post:

As usual, a very interesting post.  A few follow up thoughts.

  • No question that including “is void” is a good idea.  However, at least under the Restatement (Second) of Contracts, the nature of a membership interest (not merely economic rights) should produce the same result at least in a member-managed company.
    • A membership interest reflects a contract, with a member having both rights and duties (including fiduciary duties).  Contract law limits assignability and delegation in “personal services” and similar situations.
    • Restatement (Second) of Contracts § 317(2)(a)(1981)
      • A contractual right can be assigned unless the substitution of a right of the assignee for the right of the assignor would materially change the duty of the obligor, or materially increase the burden or risk imposed on him by his contract, or materially impair his chance of obtaining return performance, or materially reduce its value to him.
    • Comment d.
      • Material variation. What is a material variation, an increase in burden or risk, or an impairment of the obligor’s expectation of counter-performance under paragraph (2)(a) depends on the nature of the contract and on the circumstances. … [I]f the duty is to depend on the personal discretion of one person, substitution of the personal discretion of another is likely to be a material change. The clause on material impairment of the chance of obtaining return performance operates primarily in cases where the assignment is accompanied by an improper delegation under § 318 or § 319: if the obligor is to perform in exchange for the promise of one person to render a return performance at a future time, substitution of the return promise of another impairs the obligor’s expectation of counter-performance.
    • Restatement (Second) of Contracts § 318(2)(1981) (“Unless otherwise agreed, a promise requires performance by a particular person only to the extent that the obligee has a substantial interest in having that person perform or control the acts promised.”)
    • A quite similar analysis plays into the question of what happens to a membership interest when a member becomes a debtor in bankruptcy.
  • To the best of my knowledge, only one LLC statute addresses the consequences when an attempt to assign both governance and economic rights (e.g., a full membership interest) fails.
    • Minn. Stat. § 322B.313, subd. 5
      • Subd. 5. Consequences of ineffective assignment. If any purported or attempted assignment of governance rights is ineffective for failure to obtain the consent required in subdivision 2:
        • (1) the purported or attempted assignment is ineffective in its entirety; and
        • (2) any assignment of financial rights that accompanied the purported or attempted assignment of governance rights is void.
    • Chapter 322B is the original Minnesota LLC Act, which has been superseded by Minnesota’s version of  ULLCA (2006).
  • On the circumstances of “bare naked assignees”, the comment to ULLCA (2013) 107(b) states:

Subsection (b)—The law of unincorporated business organizations is only beginning to grapple in a modern way with the tension between the rights of an organization’s owners to carry on their activities as they see fit (or have agreed) and the rights of transferees of the organization’s economic interests. Such transferees can include the heirs of business founders as well as former owners who are “locked in” as transferees of their own interests. See Section 603(a)(3).

If the law categorically favors the owners, there is a serious risk of expropriation and other abuse. On the other hand, if the law grants former owners and other transferees the right to seek judicial protection, that specter can “freeze the deal” as of the moment an owner leaves the enterprise or a third party obtains an economic interest.

There is little case law in this area, and almost all of it pertains to limited partnerships rather than LLCs. The partnership case law clearly favors the remaining owners over former owners and other transferees. See, e.g., Bauer v. Blomfield Co./Holden Joint Venture, 849 P.2d 1365, 1367, n.2 (Alaska 1993) (holding that a mere assignee “was not entitled to complain about a decision made with the consent of all the partners” and stating “[w]e are unwilling to hold that partners owe a duty of good faith and fair dealing to assignees of a partner’s interest”); Bynum v. Frisby, 73 Nev. 145, 149-50, 311 P.2d 972, 975 (1957) (“[A]n assignment of a partnership interest from one partner to a stranger does not bring that stranger into fiduciary relationship with the remaining partners nor require them to resort to dissolution in order to prevent such a relationship from arising. The stranger remains a stranger entitled only to share in the partnership’s worth and to demand an accounting upon dissolution.”) (applying UPA (1914) § 27, pertaining to rights of an assignee). See generally Daniel S. Kleinberger, The Plight of the Bare Naked Assignee, 42 SUFFOLK L. REV. 587 (2009).

This subsection follows Bauer and other cases by expressly subjecting transferees (including a person dissociated as a member) to operating agreement amendments made after the transfer or dissociation, except amendments that increase obligations on transferees. For example, an amendment might extend the duration of a limited liability company but may not institute a new capital call obligation on transferees.

The question of whether, in extreme and sufficiently harsh circumstances, transferees might be able to claim some type of duty or obligation to protect against expropriation awaits development in the case law. An unreported LLC case suggests the answer might be yes, but the decision rests primarily on the wording of the LLC’s operating agreement.  In Kohannim v. Katoli, 08-11-00155-CV, 2013 WL 3943078, at *10-11 (Tex. App. July 24, 2013), the court: (i) noted that the LLC’s “Regulations provide[] for the distribution of ‘available cash’ to members quarterly provided that the available cash is not needed for a reasonable working capital reserve”; (ii) also noted that “Jacob [the defendant member] paid himself $100,000 for management services that were not performed and failed to make any profit distributions to Mike [former member and ex-spouse of the plaintiff Parvaneh] or Parvaneh [ex-spouse of Mike, who became Mike’s transferee as part of their divorce proceeding] even though more than $250,000 in undistributed profit had accumulated in the company’s accounts since the mortgage on the property had been paid off in February 2007”; and (iii) concluded that “more than a scintilla of evidence supports the trial court’s finding that Jacob failed to make profit distributions to Parvaneh.” In essence, the court upheld a finding that Jacob had breached (or caused the LLC to breach) a contractual obligation to make distributions. But the court went further: “We also agree with the trial court’s conclusion that the established facts demonstrated Jacob engaged in wrongful conduct and exhibited a lack of fair dealing in the company’s affairs to the prejudice of Parvaneh.” Id. at *11.

 

 

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