Derivative suits in two-person LLCs

In Baron v. Rocketboom, LLC (HT Mahler) an LLC that runs a website on Internet culture was financed by a loan from the 51% owner’s father, Fred Baron. Fred sued Rocketboom for nonpayment and to foreclose on the collateral. The 49% owner moved to intervene, alleging that she hadn’t consented to the loan and that the son/co-owner wasn’t protecting her interest. While the motion was pending, in June 2007, the LLC (i..e., the son) settled with Fred for $800,000.

The court denied the intervention under a provision of the LLC act that “a member of a limited liability company is not a proper party to proceedings by or against a limited liability company, except where the object is to enforce a member's right against or liability to the limited liability company.” Because the member had no individual right in the company’s assets she had to sue derivatively, citing Tzolis v. Wolff.

I have already criticized the Tzolis case for inserting a judicially implied derivative remedy into a statute that seemed designed to exclude this remedy. The court reasoned that the remedy was necessary. But in this article  I show that this reasoning is misguided. In fact, a suit by the owners directly or authorized by the disinterested owners is far more appropriate for a two-member firm like Rocketboom.

This was basically a dispute between the members, with a minority owner concerned about collusion between the majority owner and his creditor-father. Forcing this dispute into the corporate derivative mold results in useless formality. Worse, it forces the members, through the LLC, to share the costs of what is effectively individual rather than collective litigation.

In short, Tzolis imposes a litigation tax on small firms.  In a perfect world, the legislature would reverse it.  That's unlikely.  But at least NY-based LLCs can consider forming elsewhere.

Update:  Yes, Fred Baron, the guy who sued his son to start this case, is (or rather was) the Fred Baron, who knew a thing or two about lawsuits.

Comments

[business incorporation]

Thanks for the interesting article.

At the end of the article, you mention that NY LLCs can form elsewhere. How do the laws differ if the business is registered as a LLC in another state?

[Florida attorney]

We have a similar situation in a Florida case in which one of the members conspired with a manufacturer of its products to enter into "loans" for which there was no possibility or expectation of repayment and then consented to a foreclosure of the loans on all assets of the business, effectively wiping out the value of the other member's interest. The other member was not permitted to intervene in the foreclosure case.

Florida attorney