• Woe Unto the Undocumented LLC Member Seeking Judicial Dissolution
  • June 22, 2012 | Author: Peter A. Mahler
  • Law Firm: Farrell Fritz, P.C. - New York Office
  • This is the story of a tattoo artist, the tattoo-ee with whom he went into business, the deterioration of their business relationship, and the unsuccessful judicial dissolution petition that followed. But mostly, it's about what can happen when LLC members fail to document their ownership percentages and management rights, and how foolhardy it is to become a member of an LLC with no operating agreement.

    David Wallin is a tattoo artist. Dina DiCenso is a former equity analyst who got a tattoo from Wallin. In July 2009, Wallin and DiCenso opened a tattoo parlor, gallery and retail store in Brooklyn called Eight of Swords, the same name given to the limited liability company they formed to operate the business. DiCenso loaned $31,000 for start-up funding, provided administrative and management services, and personally guaranteed the lease. Wallin gave the customers tattoos.

    Wallin and DiCenso had no written agreement. They orally agreed that Wallin would receive all of the net revenues from his tattoo customers after payment of the LLC's expenses, while DiCenso would receive 30% of the LLC's gross revenue from merchandise sales and fees received from guest tattoo artists.

    Within six months the relationship between Wallin and DiCenso unraveled over management and accounting disputes. In April 2010, DiCenso petitioned for judicial dissolution of the LLC under §702 of the LLC Law, claiming that Wallin had locked her out of the business and usurped her co-equal management rights. Wallin counterclaimed for a judgment declaring that he is the 100% owner of the LLC.

    The Trial Court's Decision

    Justice Carolyn E. Demarest of the Brooklyn Commercial Division conducted a bench trial of DiCenso's dissolution claim. DiCenso testified that her agreement with Wallin was that she would manage the business and he would tattoo, and that they were 50/50 partners. Wallin testified that it was his tattoo studio and that he made all the decisions.

    In an unpublished order denying DiCenso's petition, dated January 13, 2011, Justice Demarest held that the members' ownership interests must be based on their relative "contributions" to the business; that DiCenso's $31,000 loan was not a capital contribution; that Wallin's contribution of labor was "the key to the business"; that Wallin was the "primary and virtually sole generator of revenue"; that based on "agreement between the parties and the operation of the business," Wallin is the "sole managing member"; that DiCenso held a "minimal" membership interest, "certainly less than 20% [and] it may be as little as 1% to 5%"; that the LLC's business purpose was being achieved; and that the LLC remained financially feasible.

    The Appeal

    DiCenso appealed. Her appeal brief cited LLC Law §402(a) and §503 in support of her argument that the trial court erroneously found that DiCenso held a minority interest in the LLC because she received less of its revenue. Section 402(a) states that, except as provided in the operating agreement, each member "shall vote in proportion to such member's share of the current profits of the [LLC] in accordance with [§503]." Section 503 states that, except as provided in the operating agreement, the "profits and losses shall be allocated on the basis of value, as stated in the records of the [LLC] if so stated, of the contributions of each member . . .." The term "contributions" is defined in LLC Law §102(f) and §501 as "cash, property or services rendered or a promissory note or other binding obligation to contribute cash or property or to render services."

    DiCenso argued that her contributions to the LLC were "significant" and that the trial court should have accepted her testimony that the business was to be managed and controlled by her and Wallin equally. She further argued that, under the test articulated in Matter of 1545 Ocean Avenue, LLC, 72 AD3d 121 (2d Dept 2010), dissolution was warranted because of the failure of the LLC to achieve its purpose to open a tattoo business "that both owners would jointly run."

    Wallin's opposing brief argued that the trial court correctly applied LLC Law §§402 and 503 in determining that, based on the court's assessment of DiCenso's and Wallin's relative contributions, DiCenso had a minority interest in the LLC. Wallin also argued that the trial court faithfully applied 1545 Ocean Avenue's standard in denying dissolution based on Justice Demarest's findings that the LLC's purpose, to operate a tattoo parlor, was being achieved and that the LLC was financially viable.

    Last week's decision by the Appellate Division, Second Department, in Matter of Eight Swords, LLC, 2012 NY Slip Op 04745 (2d Dept June 13, 2012), affirmed Justice Demarest's order dismissing DiCenso's dissolution petition. The appellate panel held that the lower court

    appropriately based its findings upon the petitioner's contributions to the LLC, which overwhelmingly consisted of services rendered to the LLC in the form of preparing and filing start-up documentation and performing activities associated with the renovation of the business's premises (see Limited Liability Company Law § 501). As the Supreme Court found, the petitioner's loan to the LLC did not constitute a capital contribution (see e.g. Hynes v Barr, 225 AD2d 588).

    The panel also rejected DiCenso's argument for dissolution based on the frustrated joint-management purpose of the LLC, writing as follows:

    Moreover, the Supreme Court providently exercised its discretion in denying the petition to dissolve the LLC pursuant to Limited Liability Company Law § 702, based upon its findings that the purpose of the LLC was being achieved and that the LLC remained financially feasible (see Matter of 1545 Ocean Ave., LLC, 72 AD3d at 131). The evidence adduced at the hearing fully supports the court's finding that the primary purpose of the LLC was to operate a tattoo shop at which the respondent worked as the primary tattoo artist. The petitioner's claim that the purpose of the LLC included the allocation of management responsibilities of the members of this member-managed LLC is unsupported by the evidence. On appeal, the petitioner does not dispute the court's finding that the operation of the LLC continued to be financially feasible.

    A Few Closing Observations

    • LLC Law §417(a) requires the members of an LLC to adopt a written operating agreement but imposes no consequences for failure to do so. In the real world, many LLCs are formed without operating agreements, in which event the Form K-1s filed with the LLC's tax returns may be the only reliable evidence of the member's ownership percentages. In Eight of Swords, no mention is made of the K-1s which leads me to believe that the LLC's initial tax return for 2009 was not prepared by the time DiCenso filed for dissolution in April 2010.
    • It bears repeating, anyone who becomes an LLC member without a written operating agreement at least setting forth ownership percentages and management rights is asking for trouble. Eight of Swords illustrates the inherently subjective assessment the court must make under the statutory definition of "contribution" which includes non-cash consideration such as services. Does anyone really want to leave it up to a court to value their services in determining their ownership percentage?
    • Eight of Swords also illustrates the high hurdles to be overcome by a minority member of an LLC to establish grounds for judicial dissolution under LLC Law §702 when there is no operating agreement. If the minority member can show neither management deadlock nor the majority's violation of express agreement preventing the LLC from achieving its purpose, under the 1545 Ocean Avenue formulation that leaves only lack of financial viability as ground for dissolution.  

    My thanks to attorney Howard Koh, who represented DiCenso on the appeal, for providing copies of the appellate briefs. Mr. Koh was not involved in the trial court proceedings.