• Court Orders Dissolution of Unprofitable Real Estate LLC
  • January 18, 2012 | Author: Peter A. Mahler
  • Law Firm: Farrell Fritz, P.C. - New York Office
  • Back in 2008, I wrote a couple of posts about the Youngwall case in which the court ordered involuntary dissolution of a commercial real estate limited liability company (LLC) owned 50/50 by two brothers who also were involved in a bitter dispute over their father's will, based on the personal animosity between the brothers and because the vacant building was losing money.

    Youngwall foreshadowed the landmark decision in 2010 by the Appellate Division, Second Department, in the 1545 Ocean Avenue case, which redefined the standard for judicial dissolution of LLCs under §702 of the LLC Law as requiring the petitioner to show "in the context of the terms of the operating agreement or articles of incorporation, that (1) the management of the entity is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved, or (2) continuing the entity is financially unfeasible."

    I emphasize the disjunctive "or" in the quoted passage because the cases involving judicial dissolution petitions based solely on financially failing LLCs are few and far between, as opposed to the more common scenarios involving management and/or money disputes between members of otherwise profitable ventures. The explanation may well be that most business people don't like to pay lawyer's fees fighting over a corpse.

    LLCs being the entity of choice for real estate holding companies, and the real estate market having remained in a slump the last four years, it was only a matter of time before another Youngwall case appeared. And so it has, in the form of Mizrahi v. Cohen, 2012 NY Slip Op 50030(U) (Sup Ct Kings County Jan. 12, 2012), decided last week by Brooklyn Commercial Division Justice Carolyn E. Demarest.

    Mizrahi, like Youngwall, is a family feud between brothers-in-law -- one a dentist, the other an optometrist -- who in 1999 purchased a property in Brooklyn's Gravesend section and subsequently built a mixed-use building to house their own businesses and to rent to other tenants. They formed an LLC named 372-376 Avenue U Realty, LLC to own the property and entered into a written Operating Agreement as 50/50 managing members.

    The LLC obtained mortgage financing, personally guaranteed by both members, for the purchase of the realty and construction of the four-story building which wasn't completed and occupied until 2006 when the original mortgage was refinanced in the sum of $4.7 million. The plaintiff dentist, Mizrahi, occupied a second floor office and the defendant optometrist, Cohen, occupied a smaller ground floor unit.

    At the outset the two members contributed $100,000 each. The Operating Agreement required no additional capital contribution absent the members' unanimous consent. The Operating Agreement also generally provided for unanimous approval of "any matter coming before the Members."

    Until 2003, the two members made additional capital contributions in equal shares to cover expenses. After 2003, Mizrahi made substantial, unmatched contributions and loans to the LLC. By the time of trial in 2011, Mizrahi's capital contributions totaled almost $1.2 million compared to about $300,000 for Cohen.

    In 2010, Mizrahi filed a complaint seeking judicial dissolution of the LLC and asserting claims against Cohen for an accounting and damages for alleged embezzlement of LLC funds and failure to make his share of capital contributions.

    Justice Demarest's analysis of the dissolution claim begins by citing 1545 Ocean Avenue and other cases for the proposition that "the court must look to the Operating Agreement to determine the rules applicable to the operation of a particular LLC" and that "[o]nly where the Operating Agreement is ambiguous, contrary to law or does not contain any provision for the particular matter at issue, do the statutory provisions of the [LLC Law] control."

    Mizrahi centered his dissolution claim on Cohen's alleged failure to carry his "fair share" of the financial responsibility for the real estate business under the terms of the Operating Agreement. He also claimed, and Justice Demarest agreed, that Cohen breached fiduciary duty by withdrawing $230,000 that the LLC could ill afford as a loan to himself, after Mizrahi withheld his consent.

    Cohen argued that the dissolution claim should be dismissed because the Operating Agreement limits the conditions under which the LLC can be dissolved to the members' unanimous consent or certain defined events of "involuntary withdrawal" by a member which were not present. Justice Demarest labeled the argument "specious," stating:

    Such interpretation of the law would void the statutory provision for judicial dissolution pursuant to Section 702 of the LLCL in any situation in which an operating agreement provided for dissolution only on consent or at the end of a definite term of duration for the LLC, and would thus thwart the obvious legislative intent of LLCL §702, to provide a mechanism to equitably terminate a business relationship that is dysfunctional or abusive, without the consent of all of the members.

    Justice Demarest instead posed the central question in the case as

    whether plaintiff has borne his burden to demonstrate that it is impracticable to continue the operation of the LLC in light of Cohen's failure to provide needed financial support and his undermining of the LLC's financial integrity so as to warrant dissolution of the LLC.

    The answer came largely from the LLC's accountant, who testified that the LLC consistently operated at annual losses totaling over $1.1 million in the years 2006 (when the building was first occupied) through the trial in 2011, which loss was covered by application of mortgage proceeds to the day-to-day operations of the LLC and by Mizrahi's capital contributions which prevented foreclosure on the property. Justice Demarest also credited the accountant's testimony that the monthly carrying charges for mortgage, taxes and building expenses totaling over $51,000 exceeded the rent roll by about $12,000 per month. Cohen's contention that the LLC "going forward" will show a profit, Justice Demarest commented, "appears to be based on speculation and wishful thinking."

    Justice Demarest concluded that "given the significant losses sustained over the years, which were covered by plaintiff, it is not plausible that continuing the LLC, as presently constituted, is feasible." Under the Operating Agreement's terms, the plaintiff Mizrahi is under no obligation to continue making capital contributions to keep the LLC afloat. Justice Demarest's fuller explanation is worth reading:

    In 1545 Ocean, the Appellate Court cautioned that "[d]issolution is a drastic remedy", not to be lightly ordered merely based upon disagreement, or even deadlock, among the members of the LLC, but that "where the economic purpose of the limited liability company is not met, dissolution is appropriate"(72 AD3d at 129-131). In the case here, the agreed purpose of the LLC is the development and management of a mixed-use building, presumably for the economic benefit of its members. That purpose was achieved by the construction and occupancy of the building, but the expected profit has not been realized and the building does not support the costs of its maintenance, including payment of the mortgage taken to finance the project. The deficit has consistently been financed unilaterally by plaintiff, who, under the terms of the Operating Agreement, cannot be liable for the debts of the LLC (Section 3.2). Defendant not only has failed to contribute equally in meeting the losses, but has affirmatively undermined the financial integrity of the LLC by withdrawing a substantial portion of his capital contributions, thus evidencing his inability or unwillingness to permit or promote the purpose of the LLC. Under these circumstances, it is only a matter of time, should plaintiff choose to exercise his right to refrain from making additional capital contributions or loans to the LLC, before the LLC will default upon its mortgage and the mortgage will be foreclosed, thus eliminating the sole purpose of the LLC. Accordingly, plaintiff has established that continuing the LLC is financially unfeasible and that the LLC should be dissolved. (See Mehraban v McIntosh, 2011 WL 486101, p.3 [Sup St, Nassau Co., 2011]).

    The plaintiff also contended that, upon dissolution, he should be allocated a greater than 50% interest in the LLC proportional to his capital contributions and should be permitted to purchase Cohen's diminished interest. The plaintiff relied on Matter of Superior Vending, about which I wrote, where the court ordered an equitable "liquidation" by means of requiring one member of the LLC to pay the other an amount equal to his investment in the LLC plus interest. Justice Demarest didn't buy it, distinguishing the two cases as follows:

    Superior Vending involved a limited liability company formed to acquire and operate a vending machine company. The business had been originated by one of the members through his own corporation and was expanded to a second company through investments made by the other member three years later. No operating agreement was ever executed and the relationship of the LLC members terminated after two years, but the LLC continued to operate under the management of the original member. An initial effort to dissolve Superior Vending was abandoned by the departing member, but a new petition was brought three years later to recover his share of the assets and interim distributions. Unlike the case here, the members consented to dissolution and had severed their mutual operation of the business years prior to the litigation. Because one member had continued to operate, and had expanded, the business in the intervening years, the court found it appropriate, after determining the departing member's right to recovery on his investment, to permit the remaining member to purchase, or buy-out, the other member's interest for that sum, notwithstanding the absence of a provision for such relief in the LLCL. As is apparent from the stated facts of that case, the equities of the Superior Vending case differ from the circumstances at bar in which both members have remained active in the operation of the LLC and there has been no hiatus in their joint participation, other than that created by plaintiff's removal of the bank account from access by defendant.

    The Mizrahi opinion, besides ordering dissolution and appointing the company accountant to perform an accounting, addresses a number of other interesting factual and legal issues, so do yourself a favor and read it in its entirety.