Recently, the New York appellate court with jurisdiction over our region (Appellate Division, Second Department) gave majority owners of a limited liability company (“LLC”) yet another powerful legal tool to remove minority members from the business where there is no controlling Operating Agreement. Farro v Schochet, 190 AD3d 689 [2d Dept 2021].
Referred to as a “freeze-out” or “cash-out” merger, majority owners may form a new LLC which they exclusively own, then have that company acquire the LLC owned with the minority member (which I’ll call the “target LLC”). The transaction can be authorized by the target LLC by a simple majority vote; or, even more advantageously for the majority owners of the target LLC, by a written consent signed only by the majority owners, without the need to call or hold a company meeting.
According to the Second Department, the minority owner’s sole remedy when frozen out of the business in this manner is to be paid in cash for the fair value of his/her ownership interest in the target LLC. In fact, it appears that once the majority owners complete the merger without the minority owner, the minority owner isn’t even an LLC member anymore—merely a former member with a claim for payment. The former minority member cannot sue to challenge the validity of the merger (with very limited exceptions), nor bring claims against the majority owners on behalf of the target LLC (i.e., “derivative” claims), nor sue the majority owners individually for breach of contract, breach of fiduciary duty, fraud, failure to give notice of the merger, etc.
In other words, it seems that the Second Department has endorsed the approach of “take your money and go away” as a legally viable means of removing minority owners from an LLC—but only if there is no Operating Agreement to say otherwise.
On this last point, I need to note that several years ago, a different Appellate Division, the First Department, held that if the owners of an LLC fail to adopt an Operating Agreement at the formation of the company, the majority owners can adopt a binding Operating Agreement at any time without the consent or input of minority owners. Shapiro v Ettenson, 146 AD3d 650 [1st Dept 2017]. Such a unilaterally-imposed agreement could include business terms that were never actually agreed to by the minority owner(s)—but those terms would be binding, anyway.
It therefore appears that individuals who plan to take a minority (less than 50%) stake in a new venture need to be extremely wary of doing business as an LLC without negotiating a comprehensive Operating Agreement at the outset. A minority owner who falls out of favor with the majority, or who simply ends up on the wrong end of the other owners’ misconduct, may find him/herself either bound to an Operating Agreement with unfair terms, or may get frozen out of the business entirely by a merger of the type described above. And, unless the majority owners have done something fairly egregious, it appears that there is very little the minority owner can do about it.
So, while LLCs are often recommended for small business owners due to their flexibility, and one can readily form one inexpensively on the internet or through non-attorneys, the legal reality of doing business as an LLC in New York may require significant thought and up-front cost, due to the need for all would-be owners to obtain legal counsel to negotiate and draft an appropriate Operating Agreement at the outset.
Michael R. Frascarelli, who may be reached at email@example.com, is an attorney and counselor at law focusing his practice on general commercial litigation, construction contracts and litigation, business law and ownership disputes, intellectual property, insurance coverage, bankruptcy, environmental law, land use, employment, health care, appeals, and other matters before state and federal courts. He also represents clients in alternative dispute resolution proceedings (mediation and arbitration) and in pre-litigation preparations and negotiations.
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