• Freeze-Out Merger and the Limited Liability Company
  • November 25, 2011 | Author: Peter A. Mahler
  • Law Firm: Farrell Fritz, P.C. - New York Office
  • There are many reported decisions addressing the rights of dissenting minority shareholders in merged corporations to receive cash payment for the fair value of their shares pursuant to an appraisal proceeding. Dissenters' rghts, embodied in statutes enacted over 100 years ago, protect minority shareholders from majority actions that fundamentally change the nature of their investment without their consent, while abrogating the ancient common-law rule that permitted a single shareholder to block a merger.

    There's also ample statutory and case law addressing the rights of the controlling shareholders to compel the cashing out of a minority shareholder for fair value subject to appraisal, in what's known as a "freeze-out merger."

    But what about that relatively recent invention, the limited liability company? Do minority members of LLCs have a statutory right to demand payment for their interest if the LLC is merged into another entity? Can the majority members force a minority member to cash out his or her interest in a freeze-out merger? Is there any case law on the subject?

    Yes, the LLC laws in New York and some other states make provision for dissenters' rights.

    Yes, the majority can effectuate a freeze-out merger.

    Yes, there is decisional law but the cases are few and hard to find.

    Let's begin with the New York statutes. LLC Law §1002, which closely resembles §121-1102 of the New York Revised Limited Partnership Law, authorizes and governs the procedures for merger or consolidation of an LLC with another business entity be it an LLC or some other entity form. Subdivision "(b)" requires the LLC and the other entity to adopt an agreement of merger or consolidation setting forth the terms and conditions of the conversion of the membership interests into interests in the surviving entity. Subdivision "(c)" requires approval of the merger or consolidation by a majority in interest of the members or by such other percentage required by the operating agreement. Subdivision "(e)" authorizes a member to file a written notice of dissent from the proposed merger or consolidation. Subdivision "(f)" provides that, upon the effectiveness of the merger or consolidation, the dissenting member loses his or her membership status and becomes entitled to receive in cash from the surviving company the "fair value" of his or her membership interest. Subdivision "(g)" provides that a dissenting member "shall not have any right at law or in equity" to challenge the validity of the merger or consolidation or to have it rescinded except for an attack based on noncompliance with the operating agreement or subdivision "(c)" of §1002.

    The payment for the former member's interest is governed by LLC Law §1005, subdivision "(a)" of which requires the surviving or resulting company within 10 days after the effective date of the merger or consolidation to send to the dissenting member a written offer to pay in cash the fair value of the membership interest and, if the offer is accepted, to make the payment within 10 days after such acceptance. Under subdivision "(b)," if no agreement on price is reached within 90 days after the offer, or if the surviving or resulting company fails to make an offer within 10 days, the judicial appraisal procedure provided for in §623 of the Business Corporation Law shall apply.

    According to LLC maven Doug Batey, the LLC laws in California, Florida and Minnesota also have provisions for dissenters' rights, whereas §18-210 of Delaware's LLC Act merely authorizes the operating agreement to provide contractual appraisal rights.

    New York's LLC Law was enacted in 1994. Are there any New York cases in the last 17 years construing or applying LLC dissenters' rights? To my knowledge, there's only one, an unreported decision last year by Manhattan Commercial Division Justice Charles E. Ramos in Stulman v. John Dory LLC, Mem. Decision, Index No. 602365/09 (Sup Ct NY County Sept. 10, 2010), in which a 20% managing member was involuntarily cashed out of an LLC in a freeze-out merger effectuated for the specific purpose of expelling him from the business.

    The plaintiff Stulman and the two individual defendants were each 20% managing members of John Dory LLC (JD) which operated a restaurant in Greenwich Village called Market Table. The remaining 40% was divided among nine other, non-voting members. Following a dispute with his co-managers, in March 2008, Stulman resigned as a managing member but retained a 20% non-voting interest.

    A little over a year later, JD sent Stulman a notice that a merger had been effectuated between it and John Dory Merger LLC (JD Merger), with JD Merger the surviving entity, which resulted in the termination of Stulman's interest. Under the merger agreement, all of the JD members except Stulman received one unit of JD Merger for each unit of their interest in JD. The agreement only entitled Stulman to receive cash in exchange for his interest in JD. The notice offered Stulman slightly over $100,000 for his membership interest.

    Stulman, who was not given advance notice of the merger, rejected the offer and sued. His complaint asserted claims for breach of contract, conversion, declaratory judgment, rescission and valuation on the basis that he was not given prior notice of the merger which, he alleged, therefore was ineffective, and that the $100,000 offer did not represent the fair value of his interest in JD which allegedly exceeded $300,000.

    JD and the individual defendants moved for partial summary judgment declaring that the merger was effective. They argued that, pursuant to LLC Law §407(a), a meeting of the members upon advance notice to approve the merger was not required because the written consent to the merger of all the voting members had been obtained. They also argued that, under LLC Law §1002(g), Stulman was foreclosed from asserting any common law claim for rescission or otherwise, and that his sole remedy was to pursue his appraisal rights.

    Justice Ramos agreed with the defendants and granted them partial summary judgment upholding the freeze-out merger. First, he found wanting for support Stulman's argument that the absence of a notice requirement prior to merger in the LLC Law, such as the one provided in the Business Corporation Law, was an "inadvertent omission." Having obtained written consents from all the other members as authorized by LLC Law §407(a), JD had no obligation to give Stulman prior notice of the merger.

    Second, Justice Ramos concludes that, under LLC Law §§1002(c), (g) and 1005(b), the valid membership approval of the merger forecloses Stulman from pursuing any legal or equitable remedies other than his appraisal rights. Justice Ramos also observes that §1002(g) omits any exception for actions based on fraud, illegality or self-dealing as provided by §623(k) of the Business Corporation Law. The latter point echoes the New York Court of Appeals' holding in Appleton Acquisition, LLC v. National Housing Partnership, 10 NY3d 250 (2008), in which it likewise limited the remedies available to a dissenting limited partner under Partnership Law §121-1102(d) which closely tracks LLC Law §1002(g).

    Third, Justice Ramos finds no evidence supporting Stulman's contention that the merger lacked a valid business purpose. "The removal of members," Justice Ramos writes, "qualifies as an independent corporate purpose when the 'removal of the minority shareholders, furthers the objective of conferring some general gain upon the corporation'" (quoting Alpert v. 28 Williams St. Corp., 63 NY2d 557, 573 [1984]). The defendants alleged without contradiction by Stulman that, while he was still a manager of JD, Stulman attempted to open a competing restaurant and, after he resigned, he solicited JD employees for his new venture that opened in 2009. Such evidence "clearly demonstrates that the managing members were acting in the best interests of John Dory by removing Stulman as a member because he was attempting to compete against John Dory."

    The decision accordingly dismisses Stulman's request for a declaration that he remains a member in good standing of JD; dismisses all of Stulman's claims for relief other than determining the fair value of his membership interest; and orders that the fair value proceeding be referred to a Special Referee to hear and report with recommendations.

    The growing popularity of LLCs, and the relatively infrequent inclusion of member expulsion provisions in LLC operating agreements, makes it likely that we will see more freeze-out mergers resulting from disputes between majority and minority LLC members.

    A tip of the hat to attorney John Dunne, who represented the defendants in Stulman, for sending me the decision.