• When is Permitted Collateral Assignment of LLC Membership Interest a Prohibited Sale?
  • July 16, 2013 | Author: Peter A. Mahler
  • Law Firm: Farrell Fritz, P.C. - New York Office
  • New York’s statutory default rules governing transfer of LLC membership interests, codified in LLC Law §§ 603 and 604, authorize an “assignment” of the economic rights associated with the interest but condition the assignee’s attainment of full member status, inclusive of voting and management rights, on the consent of a majority of the LLC’s members other than the assignor.

    The overwhelming majority of LLC agreements I’ve come across flip the default rule and prohibit all manner of assignment absent the other members’ or managers’ consent and/or is made subject to a right of first refusal. Most agreements take it a step further, also banning or heavily restricting a member’s right to pledge or grant a security interest in his or her interest.

    Prohibitions and restrictions of this type promote a variety of interests, first and foremost among them the ”pick your partner” principle. Another such interest is maintaining the balance of voting power and management control within multi-member LLCs. The latter interest was crucial in the Delaware Chancery Court’s 2011 ruling in the Achaian case, in which a 50/50 deadlock requiring dissolution ensued when the court construed disputed language in the LLC agreement to permit a 25% member to transfer full membership rights to another 25% member without the third, 50% member’s consent.

    Shao v. Li, 2013 NY Slip Op 51079 (U) (Sup Ct NY County July 9, 2013), decided last week by Manhattan Commercial Division Justice Charles E. Ramos, offers another interesting look at the subject. Shao involved an effort to circumvent the LLC agreement’s membership interest transfer restrictions by fashioning an agreement between two of the LLC’s three members that characterized the conveyance of economic, management and voting rights from one to the other as a permitted “pledge” in the form of a collateral assignment and security interest. Justice Ramos agreed with the aggrieved third member that the transaction was an outright assignment (sale) of the membership interest rather than a collateral assignment, thereby resulting in a prohibited transfer of the membership interest.

    Shao involves a real estate venture among Messrs. Chang, Li and Shao who directly or indirectly owned 50.1%, 23.7% and 23.7% membership interests, respectively, in an LLC that held the long-term net lease for a shopping mall in Flushing, New York. The LLC’s original operating agreement required a 75% super-majority vote for a broad range of ownership decisions, effectively requiring unanimity.

    The original agreement also included membership interest transfer restrictions. First, it contained a general restraint on transfers of any kind, stating that “[e]xcept as set forth in this Agreement, no Member shall gift, sell, assign, pledge, hypothecate, exchange or otherwise transfer to another person any portion of a Membership Interest.” Second, it provided that a member desiring to sell his interest must provide notice of a bona fide offer to the other members and that each non-selling member has a right of first refusal with respect to the sale of any membership interest in the LLC.

    The Amended LLC Agreement

    The three members later entered into an amended LLC agreement that restructured the ownership interests without changing their beneficial ownership percentages. There were, however, two other, significant changes. One was lowering the super-majority voting percentage from 75% to 73%, and the other was amending the above-quoted provision restricting membership interest transfers, by deleting the words, “assign, pledge, hypothecate” and adding a new sentence affirmatively permitting a member to pledge his interest. Here’s how the new provision read:

    "Except as set forth in this Agreement, no Member shall gift, sell, exchange or otherwise transfer to another person any portion of a Membership Interest. Nothing contained herein shall be deemed to prohibit a Member from pledging his Membership Interest

    The Assignment

    Concurrently with the amended LLC agreement, but unknown to Shao, Chang and Li entered into a side agreement whereby Chang irrevocably assigned to Li all rights and benefits arising from Chang’s membership interest including management and voting rights, profits and the right to return of capital contributions.

    In exchange, Li gave Chang $1.52 million as an “advance” payment of Chang’s capital contribution plus $50,000 per month during the assignment’s term defined as until the end of the lease term in 2027 plus any future renewals.

    In addition to the side agreement, Li and Chang executed a security agreement, irrevocable proxy, power of attorney and a manager authorization agreement giving Li the power to make “any and all necessary decisions” that Chang would otherwise be empowered to make.

    Chang, who apparently remained a member of record for tax purposes, did not treat the transaction as a sale of his interest and did not offer his interest to the other members pursuant to the LLC agreement’s provision for right of first refusal.

    The Lawsuit

    The agreement with Chang gave Li a combined voting interest in excess of the 73% super-majority threshold, which Li exercised to remove Shao as manager of the LLC. This prompted Shao to file a lawsuit, inter alia, challenging the Li/Chang assignment as a prohibited transfer under the amended LLC agreement.

    Shao’s brief in support of his motion for partial summary judgment argued that the Li/Chang transaction was an unqualified, general assignment of Chang’s membership interest tantamount to an outright sale, disguised as an assignment of collateral for security in order to avoid Shao’s right of first refusal. Li’s opposing brief countered that, by the terms of the amended LLC agreement, the assignment of beneficial ownership, management, control or voting rights was not restricted and did not trigger the right of first refusal.

    The Court’s Finding that Chang and Li Breached the Amended Agreement

    Justice Ramos agreed with Shao that the irrevocable assignment by Chang to Li of all of the rights associated with Chang’s membership interest was not a permitted pledge of Chang’s interest but, rather, was a prohibited transfer of Chang’s membership interest. As Justice Ramos’s decision explained:

    "[Chang] and Li clearly executed an unqualified assignment that resulted in a transfer of a portion of [Chang's] membership interest.

    As a result, the Assignment functions not as an assignment of collateral for security or a pledge of [Chang's] membership interest, as intended by [Chang] and Li, instead it functions as a general assignment that results in a transfer of a portion of [Chang's] membership interest in breach of the Amended Agreement.

    [Chang] and Li’s attempt to circumvent the Transferability Provision by pledging [Chang's] membership interest fails as a matter of law.

    The Assignment provides that [Chang] is pledging [his] [LLC] membership interest as collateral “to secure the full and prompt payment and performance of all of [Chang's] obligations under [the Assignment]” (Shao Aff., Ex. C, § 2.5).

    The Assignment provides, inter alia, that [Chang] “shall defend the title to the Collateral against all claims and demands whatsoever...and shall pay all taxes, assessments and fees relating to the Collateral” (id.).

    It is well established that a pledge is a “bailment of personal property as security for some debt or engagement” (Bank of Rochester v Jones, 4 NY 497, 507 [1851]).

    However, as far as this Court can determine, except for preserving the collateral, there are no substantive obligations owed by [Chang] that are being secured by the pledge of its membership interest. Thus, [Chang's] pledge would end upon the termination of the Assignment because there is no obligation to be satisfied that would result in the return of its membership interest.

    Thus, while pledging a membership interest is permitted under the Amended Agreement, [Chang's] pledge is improper because it fails to secure an obligation, debt, or engagement.

    Moreover, the termination provisions of the Assignment provide that upon Li’s uncured default, “[Chang] is entitled to revoke any [of the Transfer Documents]...” (id. at § 10). But, in the event that Chang revokes the Transfer Documents, the Assignment does not provide that the Assignment becomes void or is terminated, rather, the membership rights remain assigned to Li.

    But What Remedy?

    Shao’s motion for partial summary judgment asked the court to remedy the breach by declaring invalid Chang’s de facto transfer of his membership interest to Li. Did Justice Ramos grant the requested relief?

    No. Citing appellate precedent, Justice Ramos held that because the amended LLC agreement contained no provision that a prohibited transfer shall be void, “Shao is not entitled to a declaration that the Assignment and the Transfer Documents are invalid.” Instead, the wrongful transfer only gave rise to a damages claim. Justice Ramos accordingly ordered a hearing to determine the amount of damages recoverable by Shao.

    The court’s remedial ruling underscores what should have been detected as a glaring omission in the drafting of the transfer restrictions both in the original LLC agreement and the amendment. Such provisions routinely include language invalidating any transfer that violates the agreement’s terms.