The newest litigation haven: New York on LLC derivative suits

The New York Court of Appeals has decided that New York does allow LLC derivative suits despite the minor detail that the legislature quite deliberately omitted derivative suits from the LLC statute as part of a compromise to get the act passed. For other comments see the New York Law Journal and Gary Rosin.

The decision would be at least highly questionable even if the court had come up with cogent policy reasons for its result. Perhaps this policy would be relevant to legislative intent, but only if that intent were a closer issue than it was in this case.

But the majority did not come up with such a policy. Instead, the court wrongly observed that without derivative suits there would be "no remedy when corporate fiduciaries use corporate asssets to enrich themselves." In its next sentence the court admits that "[d]erivative suits are not the only only possible remedy." Then the court ungrammatically adds: "they are the one that has been recognized for most of two centuries." But since they are not the only one, they are not "the one."

Anyway, that alleged two-century history was about corporations. LLCs are derived significantly from general and limited partnerships. Derivative suits have not been widely recognized in general partnerships, and have a mixed history in limited partnerships (including in NY, as discussed below).

As the court itself noted, the plaintiff might pursue a direct remedy. The court suggests that this blurs the line between derivative and direct. But if there's no difference, what's everybody fighting about? Indeed there are differences.  Among other things, a derivative suit forces the other owners to share the attorneys' fees. The court has the temerity to suggest that it can't substitute direct for derivative remedies because this isn't "suggested by anything in the language of the Limited Liability Company Law." Seems a little late to use that argument! The plaintiff can also obtain a dissolution, either under the agreement, or by the court even if the agreement doesn't provide for it. The court can adjudicate claimed breaches of fiduciary duty in the dissolution proceeding, and allocate the assets accordingly.   

The court isn't troubled by the legislature's deliberate omission of the derivative remedy because it says it's possible some legislators figured the courts would "follow the established case law" permitting derivative suits, citing the Klebanow case in which a federal court dreamed up a derivative remedy for NY limited partnerships despite their absence from the statute. But at least in Klebanow (apart from the cheekiness of a federal court making rather than following state law) the court was not confronted with legislative history as clear as the history here.

The skillful and outraged dissenting opinion, in addition to showing that the majority is "judicially legislating a cause of action that was rejected by the Legislature," demonstrates that permitting LLC derivative suits is very much a debatable issue. The court notes that LLC law is still developing

because LLCs are a fairly recent statutory innovation, unknown to the common law; a new business form combining corporate-type limited liability with partnership tax advantages and organizational characteristics. On the matter of derivative suits in particular, there are divergent views throughout the country. The Uniform Limited Liability Company Act developed by the National Conference of Commissioners on Uniform State Laws provides for derivative suits modeled on the provisions of the Revised Uniform Limited Partnership Act. Many states have adopted laws along similar lines. By contrast, other states, preferring the American Bar Association's Prototype Limited Liability Company Act, require disinterested members or managers to authorize litigation. The co-author of the major treatise on limited liability companies-who (unlike the majority) questions the utility of derivative suits in the LLC context-advocates the ABA's approach as “a reasonable compromise” (see Ribstein, “The Emergence of the Limited Liability Company,” 51 Bus. Law. 1, 23 [1995-1996] [“If the (derivative suit) remedy is justified ..., it is only because requiring plaintiffs to seek authorization from thousands of shareholders of publicly held firms could prevent some legitimate suits,” but “[t]he same point does not apply to closely held firms. Moreover, LLC members generally have other means of self-protection at their disposal that corporate shareholders may lack, including a default right to sell their interest back to the firm and substantial veto and removal powers”] )

Indeed, I still endorse this legislative alternative to the LLC derivative suit. The basic problem with a derivative suit is that it allows a minority owner to take it upon himself to pursue litigation that can impose significant costs on the LLC. This can be quite burdensome in the small firms that are the typical LLCs. Moreover, with only a few owners, there's no need for the derivative remedy as a coordination device.  So it's better to at least let all of the disinterested owners participate in this decision.

It's worth noting the NY state court doesn't deserve all of the blame here.  It relied partly on Klebanow, which was a federal case (remember Erie?). I have previously sharply criticized a NY federal court for creating an important LLC derivative suit precedent, also relying in part on Klebanow. These cases suggest that federal courts may not be a panacea for the problems of excessive litigation.

Finally, Gary Rosin isn't troubled by this case. He analogizes the court's refusal to abide by the legislation to the "creative silence" of a contract – if the legislature didn't want the courts to do this, it should have said so explicitly. "The moral here is caveat legislator: if you mean no, just say no. See generally, Nancy Reagan."

I strenuously disagree with the contract analogy. These kinds of provisions are a lot more easily insisted on in a one-on-one contract negotiation than in the complex dynamics of a legislative process. It follows that letting judges create judicial remedies unless explicitly forbidden to do significantly weakens courts' ability to check legislatures. It should take more than a cute reference to Nancy Reagan to justify that. As the dissenters note:

the Legislature does not customarily write zipper clauses into its statutes, or explicitly prohibit the courts from implying rights or liabilities that it did not choose to include. Rather, the modern Legislature reasonably expects the judiciary to respect its policy choices.

I plan to have a lot more to say about the various jurisprudential and policy issues related to the LLC derivative suit controversy in an article later this spring.

Comments

[Peter A. Mahler]

As a practicing New York lawyer who has studied, written about (see my article on LLC dissolution in the June 2002 NY State Bar Journal), lectured on and litigated LLC dissolution cases, I take issue with the notion that the dissolution remedy provides adequate protection for the non-controlling members against fiduciary abuses by controlling members. Section 702 of the New York LLC Law is drawn from the sparse dissolution provision found in the limited partnership law, and basically requires the dissolution proponent to show that the LLC is not functioning in accordance with its operating agreement. Oppression, which is the primary ground for dissolution under the analogous New York statute governing closely held business corporations, is not part of the LLC statute. Minority LLC members are rarely successful in dissolution cases because the operating agreement typically vests control in the majority member, hence the LLC is functioning exactly as intended. None of this is meant to suggest that the Tzolis majority is right as a matter of statutory interpretation and separation of powers doctrine, or to argue that the policy advanced by the majority is the wiser one. I'm simply making the point that the policy debate should not assume an efficacious dissolution remedy as justification against derivative lawsuits.

Peter A. Mahler
www.nybusinessdivorce.com

[Larry Ribstein]

I made no such assumption. I pointed out that the question of what remedy to provide is a policy issue which in this case was decided by the legislature against the derivative action.