An LLC is a legal entity that is separate and distinct from its members, and an injury to an LLC is not the same as an injury to its members. Failure to take that distinction into account when commencing a lawsuit can lead to the dismissal of claims. An example of this unfortunate (at least from the plaintiff’s point of view) result is O’Reilly v. Valletta, 55 A.3d 583 (Conn. App. Ct. Nov. 20, 2012).
Background. HUB Associates, LLC and its sole member, John O’Reilly, sued Robert Pformer for violations of the Connecticut Unfair Trade Practices Act (CUTPA). HUB had leased real estate for a restaurant, and Pformer was a board member of the condominium association that managed the leased premises. The suit claimed that Pformer interfered with HUB’s efforts to advertise its business on the leased premises.
The trial court dismissed the CUTPA claims against Pformer on grounds that Pformer’s alleged conduct involved the management of a condominium and did not constitute “acts or practices in the conduct of any trade or commerce,” as is required to prove a violation of CUTPA. Id. at 586. O’Reilly appealed, but HUB did not appeal. Id. at 584 n.1.
The Appeal. Pformer argued on appeal that the trial court’s ruling in his favor was correct. But he went further and argued on appeal, for the first time, that O’Reilly lacked standing to bring the claim against him and that O’Reilly’s claim should therefore be dismissed for lack of subject matter jurisdiction.
Standing and subject matter jurisdiction sound technical, but they address fundamental issues of the court’s power and who may bring a lawsuit. Subject matter jurisdiction is the authority of a court to adjudicate the type of controversy presented. Courts have no power to decide cases over which they lack jurisdiction. Subject matter jurisdiction may not be waived by a party, and it may be raised by any party or by the court at any stage of the proceedings, including on appeal. Id. at 586.
One aspect of subject matter jurisdiction is standing. A court has no jurisdiction over a claim if the claimant does not have standing to assert the claim. Normally a party will have standing if it alleges direct injury to itself – the claimant’s injury must not be indirect or remote. Id. at 587.
The court considered O’Reilly’s claim and his status as the sole member of HUB. (HUB’s claim was not before the Appellate Court because the trial court had ruled against it and it had not appealed.) The court noted that an LLC is a distinct legal entity, with separate existence from its members. Therefore, “[a] member or manager … may not sue in an individual capacity to recover for an injury based on a wrong to the limited liability company.” Id.
O’Reilly’s CUTPA claim against Pformer was based entirely on allegations of Pformer’s violations of HUB’s rights and expectations that arose from HUB’s status as lessee of the premises and operator of the restaurant. Id. As sole owner of HUB, O’Reilly may have been harmed indirectly by Pformer’s alleged injuries to HUB, but the only direct harm was to HUB. The court therefore concluded that O’Reilly lacked standing, that the trial court lacked subject matter jurisdiction over the claim, and that the trial court improperly rendered judgment for Pformer on the merits of O’Reilly’s CUTPA claim. The case was remanded to the trial court to dismiss for lack of subject matter jurisdiction.
Comment. O’Reilly addresses basic issues that are sometimes taken for granted. The key to the court’s ruling is the separate nature of LLCs, their status as distinct legal entities. They can sue and be sued, own property, and enter into binding contracts. If an LLC is injured by a breach of contract, for example, it can sue the other party for breach of that contract. But its members, even a sole member, would not have standing to sue for breach of the contract because only the LLC was directly injured.
O’Reilly is also instructive about the power in litigation of the issue of subject matter jurisdiction. New legal issues cannot generally be brought up on appeal, but subject matter jurisdiction cannot be waived and can be brought up at any stage of litigation, including on appeal. If there is no subject matter jurisdiction, the claim is dismissed.
Judge Karas thoroughly dissects the plaintiff’s derivative and other claims in Cordts-Auth v. Crunk, LLC, No. 09-CV-8017, 2011 U.S. Dist. LEXIS 109600 (S.D.N.Y. Sept. 27, 2011). The opinion usefully sheds light on some of the corners of New York law on LLC derivative suits.
Plaintiff Renate Cordts-Auth filed suit on September 18, 2009, asserting:
● derivative claims for breach of fiduciary duty, tortious interference with contract, and legal malpractice;
● a direct claim for breach of contract; and
● equitable claims for an accounting, access to records, and a declaratory judgment that she was a member of Crunk, LLC at the time of the claimed wrongdoing.
The defendants moved to dismiss the lawsuit, and for purposes of the dismissal motions the court assumed the truth of the following facts, as asserted in the complaint.
Background. Cordts-Auth was a long-time employee of Sidney Frank Importing Company (SFIC), and also assisted its owner Sidney Frank in the operation of Crunk, LLC, a New York limited liability company. In 2005 Cordts-Auth was granted Performance Units in Crunk as consideration for her services. Her interest in the Performance Units was limited to the company’s post-grant-date appreciation, based on an appraisal at the time of grant.
Sidney Frank, the CEO of SFIC and Crunk, died in 2006. His daughter Catherine Halstead (Halstead) became Chairwoman of SFIC and manager and principal executive of Crunk. Her husband, Peter Halstead, became an advisor to Crunk’s management, including Cordts-Auth. Two months later, Peter informed Cordts-Auth that Halstead intended to devalue Crunk’s Performance Units and issue new units, to restructure Crunk and re-launch the company with new investors, and to defraud Crunk’s existing investors.
Cordts-Auth informed Halstead of her objections to the restructuring in February, 2007. Shortly thereafter she was removed by Halstead from her positions at SFIC and Crunk. A month later Cordts-Auth, SFIC, and Crunk entered into a separation agreement, under which Cordts-Auth agreed to resign from her positions with the companies and was paid $2 million.
Three weeks after execution of the separation agreement, Halstead wrote to Cordts-Auth. Halstead informed her that Crunk had lost $1.5 million in 2006, that Crunk had been projected to lose its remaining cash investments during the upcoming fiscal year, and that Crunk had been sold to Solvi Brands, LLC as of February 28, 2007, nine days before the date of the separation agreement. Cordts-Auth was informed that she would receive nothing for her Performance Units because the Crunk sale proceeds were less than the minimum required for the Performance Units to have any value. Two months later Crunk was dissolved.
In February 2009 Cordts-Auth requested from the re-launched Crunk an accounting of Crunk’s sale proceeds. In March 2009 she demanded a copy of the sale agreement between Crunk and Solvi, and the identities of all former interest-holders in Crunk and all current interest-holders in Solvi. Her requests were rejected and she filed the lawsuit several months later.
Analysis. The court began by reviewing Cordts-Auth’s claims to determine whether they were direct (made in her own right) or derivative (asserted on behalf of the LLC). The court applied New York law because Crunk was a New York LLC. Under New York law, a claim is considered to be derivative if the claim is for wrong done to the LLC. Id. at *15. The court viewed Cordts-Auth’s claims for breach of fiduciary duty, tortious interference, and legal malpractice as claims for injury to the LLC, and therefore characterized them as derivative claims.
Standing. The court next examined whether Cordts-Auth had standing to maintain the derivative claims. New York law requires that the plaintiff in an LLC derivative suit must have been a member of the LLC both at the time of the offending conduct and at the time the lawsuit is commenced, Id. at *17. (Many states, e.g. Delaware and Washington, have similar requirements.)
Crunk’s operating agreement set forth the requirements for an individual to be admitted as a member. The agreement required that Crunk’s Board determine the nature and amount of the Unit Consideration to be made by the individual, and the Unit Consideration must be received by the LLC. Unit Consideration is defined to be “cash or property” – services are not included. The Board made no such determination in Cordts-Auth’s case, and no Unit Consideration was paid by Cordts-Auth.
Crunk’s operating agreement also required that members holding two-thirds of Crunk’s Class A Units consent in writing to the admission of a member. That never happened. Cordts-Auth pointed out that she was listed on the operating agreement’s exhibit as a member, but the court found that the exhibit did not overcome the operating agreement’s clear membership requirements.
The court concluded that Cordts-Auth never became a member but instead was an assignee, a non-member holder of Performance Units. “Therefore, Plaintiff has failed to adequately plead that she ever attained membership in Crunk, and the Court dismisses her derivative claims on this ground alone.” Id. at *25-26.
Not content to rest on that branch of the analysis, the court also examined Cordts-Auth’s status at the time of filing the lawsuit. Cordts-Auth didn’t dispute the defendants’ contention that she was not a Crunk member when she filed suit, but she asserted that she fell within an equitable exception that applied where the transaction was fraudulent. The court found that although Delaware recognizes the equitable exception, no New York courts had applied a fraud exception to a New York LLC.
But even assuming that New York courts would apply an equitable exception to the continuous ownership requirement, the court found that Cordts-Auth did not fit into the exception. The fraud exception applies if the transaction was fraudulent and the transaction was done merely to eliminate derivative claims. Cordts-Auth alleged that the transaction was fraudulent, but not that its purpose was to eliminate derivative claims. She had no claims pending at the time of the Crunk sale, so eliminating a potential derivative suit was unlikely to have been the motivation for the transaction. Id. at *31.
Another equitable exception can apply if both the acquired company and the surviving company have engaged in wrongful or fraudulent conduct. The court found that Cordts-Auth did not allege any wrongful or fraudulent conduct by Solvi, the surviving company, so this exception did not apply. Cordts-Auth therefore lacked standing to pursue the derivative claims. Id. at *33.
Demand Requirement. Although the court found that Cordts-Auth did not have standing because she was not a member of Crunk at either of the required times (time of wrongdoing, and time of commencement of suit), it nonetheless proceeded to analyze whether Cordts-Auth had satisfied the demand requirements of a derivative lawsuit, and concluded that she had not.
There are two elements of the demand rule. The first component is procedural. Federal Rule of Civil Procedure 23.1 and the New York Business Corporation Law both require that a complaint which asserts a derivative claim must state with particularity the plaintiff’s efforts to obtain the desired action from the LLC’s managers, and the reasons for not obtaining the action or making the effort. The second component is substantive and addresses whether the demand was adequate to inform the managers of the potential cause of action so they could address the claim.
The defendants also contended that Cordts-Auth had a conflict of interest, because she was asserting on behalf of the LLC its claims against alleged wrongdoers, while at the same time pursuing her own personal claims directly against the LLC. The court dismissed that contention, because Cordts-Auth no longer held any interest in Crunk and would not receive any return as a member from the LLC’s claims.
The court found that Cordts-Auth’s complaint satisfied the particularity requirement, because it had adequate details about her demands and included copies of two demand letters she had sent to the defendants. But the substance of her demand was inadequate because it did not clearly relate to the derivative claims she was seeking to assert. She had demanded documents and information about the Crunk sale but had not mentioned potential causes of action or damages.
Cordts-Auth argued that demand would have been futile, which can excuse a failure to make demand. The court rejected this argument because Cordts-Auth did not fail to make a demand, but rather had made an inadequate demand that was refused by management. “Accordingly, the Court finds that Plaintiff has not satisfied the demand requirement, as required under New York law, and that she therefore may not pursue her derivative claims.” Cordts-Auth, 2011 U.S. Dist. LEXIS 109600, at *48.
Substance of Claims. After holding that Cordts-Auth’s derivative claims failed both because she lacked standing and because she had not satisfied either of the demand requirements (particularity and adequacy), the court then discussed the substance of some of her derivative claims in a long footnote 14. Id. at *48-53. The court didn’t rule on those issues, but expressed its skepticism about their viability.
Cordts-Auth claimed that both Crunk and Solvi breached fiduciary duties that they owed to her. Under New York law, corporations do not owe fiduciary duties to shareholders. Apparently no New York court has addressed the analogous issue for LLCs, but the court found it reasonable to extend the corporate rule to LLCs. Neither Crunk nor Solvi owed fiduciary duties to Cordts-Auth, so there could be no breach of fiduciary duties.
Cordts-Auth claimed that Solvi and the Solvi investors had tortiously interfered with her Crunk operating agreement, by inducing Crunk to sell its assets to Solvi in violation of the operating agreement. The court found it doubtful that Cordts-Auth could demonstrate that the Solvi investors induced the sale of Crunk to Solvi merely by investing in Solvi, and questioned whether the sale constituted a breach of the Crunk operating agreement.
Cordts-Auth also asserted a constructive trust claim, on the theory that her Performance Units were wrongfully transferred, but the court rejected that claim because the Performance Units were not transferred but were canceled when Crunk was dissolved.
Breach of Contract. Cordts-Auth asserted a direct claim, in her own right, for breach of contract against Crunk and Halstead. She alleged that their failure to give her notice of Crunk’s impending sale to Solvi violated Crunk’s operating agreement.
The court dismissed Cordts-Auth’s breach of contract claim against Crunk because Crunk was not a party to its operating agreement, which is an agreement between the Crunk members. “The plain language of the Crunk Agreement, and common sense, make clear that Crunk was not a party to the Crunk Agreement, and therefore could not have breached it.” Id. at *54.
(A Delaware LLC, in contrast, is bound by its operating agreement and therefore could be in breach of its own operating agreement. “A limited liability company is bound by its limited liability company agreement whether or not the limited liability company executes the limited liability company agreement.” Del. Code Ann. tit. 6 § 18-101(7).)
The court also dismissed Cordts-Auth’s breach of contract claim against Halstead. Cordts-Auth claimed that Halstead was obligated to give a “Drag Along Notice” of the impending Crunk sale. The Drag Along Notice only applied, however, if a majority of the selling Crunk members wished to force a minority to participate in a sale of their member interests. The Crunk sale was an asset sale and not a sale of member interests, so the Drag Along Notice did not apply. Further, Halstead had an optional right, but not an obligation, to give a Drag Along Notice. (No notice was required if Halstead did not exercise her Drag Along Right.) The court dismissed Cordts-Auth’s claim: the Drag Along Notice did not apply to Crunk’s asset sale and Halstead was not obligated to give the notice in any event, so there was no breach.
Accounting, Books and Records, and Declaratory Relief. Cordts-Auth asked for an accounting of the proceeds from Crunk’s sale. The court dismissed that claim, because a party seeking an accounting must establish the existence of a fiduciary relationship, and Cordts-Auth was not ever a member of Crunk and therefore failed to establish the existence of a fiduciary relationship. Additionally, her accounting claim named only Solvi and Crunk, and as the court previously noted, a New York LLC owes no fiduciary duties to its members.
Cordts-Auth also asked for access to Crunk’s books and records, and a declaratory judgment that she was a member of Crunk at the time of sale. Those claims were dismissed because only LLC members have rights to the LLCs books and records, and the court had already determined that Cordts-Auth had not been and was not a member of Crunk.
Conclusion. All of Cordts-Auth’s claims were dismissed, and her derivative claims were dismissed on several grounds. The opinion will bear study by any New York practitioner analyzing a client’s potential LLC derivative suit.
LLCs are legal entities and can sue and be sued. But a recent case from Connecticut shows that if an LLC does not properly authorize the filing of a suit, the defendant can defend on the ground that the LLC lacked standing to bring the lawsuit. 418 Meadow Street Assocs. LLC v. Clean Air Partners, LLC, 123 Conn. App. 416, 2010 Conn. App. LEXIS 369 (Aug. 24, 2010).
Wynnick and Weinshel owned 50% of 418 Meadow Street Associates LLC. Levine owned the other 50%. Wynnick and Weinshel brought suit in the name of the LLC to enforce a lease agreement against Clean Air Partners. Levine’s husband owned 20% of Clean Air Partners, and Levine was not a party to the decision to commence the lawsuit.
Clean Air Partners contended that Meadow Street did not have standing to pursue the action because Wynnick and Weinshel failed to secure the necessary LLC approval. Meadow Street, 2010 Conn. App. LEXIS at **4.
Wynnick and Weinshel conceded that the LLC’s operating agreement required a majority vote to launch a lawsuit and that only a 50% vote approved the suit. They argued, however, that Levine had an interest in the outcome of the suit that was adverse to the LLC, and that therefore under Conn. Gen. Stat. § 34-187(b) her vote could be excluded from the votes required to approve the suit. They asserted that Levine’s interest was adverse both because of her husband’s 20% ownership interest in the defendant and because, in a separate lawsuit by Levine to dissolve Meadow Street, Wynnick and Weinshel had counterclaimed against her for mismanagement and breach of fiduciary duty. Meadow Street, 2010 Conn. App. LEXIS at **5.
The court didn’t see it that way. The court’s view was that her husband’s ownership interest in the defendant was not owned by her, and that the dissolution lawsuit was separate and not sufficiently connected to the lease claim against Clean Air Partners. Id. at **9-11. The court therefore affirmed the trial court and ordered dismissal of the action.
An interesting aspect of Meadow Street is the Connecticut statute, Section 34‑187(b). This statute allows an LLC to exclude from the approval process the vote of a member or manager who has an adverse interest in the outcome of a proposed lawsuit. Neither the Delaware nor the Washington LLC Act has a similar provision. In a state without such a rule, if an LLC agreement requires a majority vote to initiate a lawsuit, a 50% member would be able to block a suit even if it was a part owner of the defendant. It’s possible, though, that in such a case the members trying to start the lawsuit might be able to maintain a claim of breach of fiduciary duty against the blocking member, especially if it was voting as a manager or as a managing member.
In Washington or in any of the other community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, and Wisconsin), the outcome in Meadow Street would likely have been different. In those states, property owned by one spouse is presumed to be owned by the community, which means that each spouse has a one-half undivided ownership interest in their community property. In a community property state, Levine’s husband’s 20% interest in the defendant likely would have been treated as her property, through the community. In that event, her vote would not have been included because of her adverse interest, and the lawsuit would have been duly approved and could have proceeded.