• Majority Member's "Egregious Breach" of Operating Agreement Leads to LLC's Judicial Dissolution
  • May 22, 2012 | Author: Peter A. Mahler
  • Law Firm: Farrell Fritz, P.C. - New York Office
  • At what point does a business partner's failure to live up to contractual promises made to his fellow partner justify the remedy of judicial dissolution of the business entity, as opposed to a lesser remedy designed to restore the aggrieved partner to the benefit of his contractual bargain? And how should that question be answered in the limited liability company (LLC) setting, where the governing dissolution standard requires the court to determine if the LLC's purpose is no longer achievable in conformity with the operating agreement's terms? 

    Such questions undoubtedly are far from the minds of the budding athletes who show up each summer at a youth baseball camp in upstate New York known as the Cooperstown All Star Village. But they were central to a recent court decision dissolving the LLC that operates the camp, after a minority member claimed that the majority members were diverting business away from the camp's hotel and restaurant facilities to nearby competing facilities separately owned by the majority members.

    The court's unreported memorandum decision in Matter of Cooperstown Capital, LLC, Index No. 2010-0315 (Sup Ct Otsego County Apr. 6, 2012), came in one of six (!) lawsuits since 2005 pitting Martin and Brenda Patton as 65% controlling members of two LLCs against Joseph Ferrara as an indirect 35% member through his holding company. One of the LLCs, called Abner Doubleday LLC ("Abner"), owns the land on which the baseball camp is located. The other, Cooperstown All Star Village, LLC ("Cooperstown"), operates the baseball camp which conducts weekly youth team tournaments throughout the summer and also includes hotel accommodations for visiting families of the campers, a restaurant, bar, general store, concession stand, laundry center and arcade center.

    As evidenced by the multiple litigations which began only a year after the baseball camp opened, the relationship between the Pattons and Ferrara has been contentious from inception. Three years ago I posted about one of the earlier cases in which Ferrara obtained a preliminary injunction, later affirmed on appeal, restraining the Pattons from enforcing a capital call directed against Ferrara alone in violation of the operating agreement's provision for pro rata contributions. The other four, pre-dissolution cases involved claims arising from a promissory note given by Ferrara in favor of the Pattons, payment for construction services provided by Ferrara during development of the camp, and alleged financial abuses by the Pattons.

    Ferrara filed his application to dissolve Abner and Cooperstown in 2010 while the five prior cases were still pending. The petition's central claim was that the Pattons were competing against Cooperstown's hospitality facilities by referring visitors to nearby off-site hotel and restaurant accommodations owned by the Pattons without Ferrara. In 2011 the court authorized Ferrara to have a forensic investigation and audit of Cooperstown. When the resulting report did not lead to a resolution, Ferrara moved to appoint a temporary receiver for the LLCs which also required the court to address the dissolution applications.

    The decision by Supreme Court Justice Kevin M. Dowd begins its analysis by citing the governing statute, LLC Law §702, which authorizes dissolution of an LLC "whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement." Justice Dowd also quotes from the Second Department's seminal opinion in the 1545 Ocean Avenue case, stating that "the dissolution of a limited liability company under LLC Law §702 is initially a contract-based analysis." Justice Dowd then proceeds to do just that, by separately examining the operating agreements for each of the two LLCs and coming to opposite conclusions for Abner and Cooperstown.

    Dissolution of Abner Denied

    Justice Dowd observes that the purpose of Abner, as provided in its operating agreement, is "to own and operate the specific piece of real property where the Baseball Camp is operated and such other properties as the members agree to acquire, manage and/or operate." The decision also quotes a provision in the operating agreement entitled Competing Business Activities, permitting the members to engage in other business ventures whether competitive or not with Abner.

    According to Justice Dowd, the main problem with Ferrara's request to dissolve Abner, apart from his petition's predominant focus on Cooperstown, is that "[t]here is no allegation that the business purpose of Abner is being thwarted." He continues:

    Abner continues to own and operate the subject real property. Based on the above quoted Competing Business Activities section of Abner's Amended and Restated Operating Agreement, there can be no claim that there is prohibited competition taking place. The only remaining claim is that safety issues have been ignored and repairs have been improperly performed. . . . [T]here has been no showing that any past safety or repair issues have rendered it not reasonably practical to carry on the business of Abner in conformity with its operating agreement. Therefore, the Petition with respect to Abner must be denied.

    Dissolution of Cooperstown Granted

    "The allegations and evidence regarding [Cooperstown] are vastly different." So begins Justice Dowd's analysis of the petition's central allegations concerning the Patton's competitive facilities. While "[m]any of the allegations raise triable issues of fact that cannot be resolved upon the submissions," Justice Dowd writes, "[t]he allegations regarding the Pattons' other businesses . . . appear to be different."

    The key difference lies in the provision in Cooperstown's operating agreement dealing with competitive business activities. Unlike the one in Abner's agreement, Section 11.1 of Cooperstown's agreement explicitly prohibits members from engaging in any "venture or investment [that is] competitive with the Camp" and further bars a member from gaining any share of income or profit from a competitive business. The provision also bars a member from engaging in or having a financial interest in any business similar to "the Facilities or the Camp" within a 50-mile radius, with the term Facilities defined to include the restaurant and hotel. In addition, the purpose clause in Cooperstown's operating agreement states that its business includes the provision of "hospitality services" relating to the baseball camp.

    Justice Dowd finds largely undisputed the evidence presented by Ferrara of the Pattons' ongoing efforts to steer business away from the baseball camp's hotel and restaurant to their own off-site facilities, in violation of Section 11.1. Such efforts include promotion of the Pattons' facilities on Cooperstown's website and flyers, which advertise room rates significantly cheaper than the Cooperstown facilities. It also was unrefuted that the camp's hotel and restaurant did not operate at full capacity.

    According to the decision, the Pattons argued that Cooperstown "is a viable company"; that "the tournament is operational and has increased the number of teams participating"; that its business income has increased since opening in 2004; and that in any event the LLC Law provides relief other than dissolution for breaches of fiduciary duty.

    Justice Dowd strongly disagreed, highlighting the magnitude and ongoing nature of the Pattons' breach of the operating agreement:

    In the present case, there is an egregious breach of the contract into which the members of [Cooperstown] entered. The Pattons are not only conspicuously competing with the services of [Cooperstown], they are utilizing [Cooperstown] to engage in this competition. The Court has examined numerous reported cases regarding the dissolution of limited liability companies. None of them presented a situation where the terms of the operating agreement were so blatantly flaunted. The Pattons' controlling interest in [Cooperstown] does not give them authority to disregard the operating agreement.

    The Pattons' suggestion, that Ferrara can pursue "other actions and claims against the Pattons for their alleged breaches of fiduciary duties," encounters similar disdain from Justice Dowd, who comments that the suggestion "exemplifies [the Pattons'] misunderstanding of the fundamental breach that is being committed." Ferrara's claims for fiduciary breach, he continues, "are not [his] only remedy nor can pursuit of those claims provide the relief [he] seeks. Petitioner is still entitled to have the contract, the operating agreement, the parties entered into enforced."

    Justice Dowd mentions other factors that convince him the Pattons "are 'unwilling' to end the prohibited practices in which they are engaging." These include the Pattons' use of their control to increase Mr. Patton's management fee from $90,000 to $215,000, and to pay Mrs. Patton a salary of $93,000, which compensation is not tied to any increase in Cooperstown's revenues. Meanwhile, there is no "incentive" for the Pattons to abide by the non-compete obligation because the increase in their other businesses does not have to be shared with Ferrara.

    Justice Dowd accordingly finds "that it is not reasonably practicable to carry on the business of Cooperstown All Star Village, LLC, in conformity with its operating agreement" under LLC Law §702. Justice Dowd also grants Ferrara's request to appoint a receiver to wind up the affairs of Cooperstown.

    A Few Closing Thoughts

    • There obviously are breaches of an LLC operating agreement for which, like any other contract, an aggrieved member can be made whole by awarding compensatory damages and/or injunctive or other equitable remedies. Ferrara likely could have established through forensic accounting the profits lost to Cooperstown as a result of the Pattons' competitive facilities. Such lesser remedies clearly did not impress Justice Dowd as sufficient to remedy what he perceived to be the Pattons' blatant, unrepentent and ongoing violations of the non-compete provision in Cooperstown's operating agreement -- violations that Justice Dowd felt fundamentally undermine its business purpose.
    • It's hard not to view the dissolution case in the context of what has turned into a seven-year litigation saga between the Pattons and Ferrara involving five prior, related lawsuits. Judges cannot be expected to turn a blind eye to the reality of a hopelessly failed business relationship when analyzing whether the standard for dissolution under §702 is met.
    • Even assuming Cooperstown's operating agreement did not include its non-compete clause, under LLC Law §409 and the case law the Pattons as managers of the LLC owed a fiduciary duty of loyalty not to engage in competitive business activities. Would violation of such fiduciary duty without the contractual overlay have warranted the same result? It's difficult to say without knowing more facts, such as whether the Pattons' competing facilities pre-existed Cooperstown and were disclosed to Ferrara before they went into business together.
    • The dissolution of Cooperstown alongside the non-dissolution of Abner create some interesting issues. Only time will tell whether the winding up of Cooperstown will result in a buy-out settlement -- in which case presumably the ownership of Abner also will change -- a sale of the camp business as a going concern to a third party, or a piecemeal liquidation of its assets. If the camp is sold to someone else as a going concern, depending on the lease terms with Abner assumed by the new owner or negotiated as part of a new lease -- negotiations controlled on Abner's side by the Pattons as managers --  the Pattons' ongoing operation of nearby, competing hospitality facilities could have an adverse impact on Abner's profitability and value. Perhaps if the Pattons appeal the dissolution of Cooperstown, and if Ferrara does the same for the denial of his request to dissolve Abner, the appellate court may end up addressing such issues.