Opinions by the Court of Appeals, New York's highest court, construing the state's LLC Law enacted 30 years ago are almost but not quite as rare as hen's teeth. The great majority of important rulings under the statute emanate from our intermediate appellate courts known as the Appellate Division.
So when a Court of Appeals opinion in a dispute between LLC members comes along, LLC aficionados like me pay maximum attention — even if the dispute involves a Delaware LLC as occurred last month in Behler v Tao.
By a 4-3 vote accompanied by a vigorous dissenting opinion, the Court of Appeals affirmed a ruling by a similarly divided Appellate Division affirming the Motion Court's decision dismissing the plaintiff minority LLC member's complaint. At issue was the plaintiff's ultimately unsuccessful bid to enforce an oral “exit opportunity agreement” with the controlling member.
Both appellate majority opinions held that a merger provision in a subsequently amended LLC agreement, unilaterally adopted by the controller, barred enforcement of the alleged oral agreement.
Why such sharp division among successive appellate panels? When I posted last year about the Appellate Division's 3-2 decision, I called it a clash between the majority's elevation of Delaware's “harsh contractarianism” over the minority's appeal to “fundamental fairness.” The same clash more or less is manifest in the Court of Appeals' majority and dissenting opinions.
A Recap of the Underlying Facts
In my post last year about the Appellate Division's decision in Behler v Tao, I detailed at great length the factual allegations in Behler's complaint concerning the alleged oral agreement, the relevant provisions in the LLC's original and amended LLC agreement, the parties' arguments in the lower court for and against enforcement of the oral agreement, the Motion Court's decision dismissing the complaint, and the Appellate Division's majority (and dissenting) opinion affirming the Motion Court's order of dismissal. For those interested, I recommend jumping to the prior post before continuing. For the rest of you, a down-sized recap follows.
Behler's complaint alleges that he and Tao had been “close friends” for years before 2012 when Tao solicited Behler to invest $3 million in a publicly traded company Tao controlled called Remark Holdings. Instead of investing directly in Remark, Tao proposed that Behler invest in a Delaware LLC called Digipac which Tao as sole member formed to hold shares in Remark.
According to Behler, he and Tao entered into an oral “exit opportunity agreement” whereby Behler invested $3 million for a 24.14% membership interest in Digipac. To accommodate Behler's concern over the illiquidity of an investment in Digipac, allegedly Tao personally guaranteed that if Remark's publicly traded shares hit $50 per share Tao would cause Digipac to sell its Remark shares and distribute the proceeds pro rata to Behler, and if the shares didn't hit $50 within five years, Tao would cash out Behler's interest in Digipac based on the then-value of Digipac's Remark holdings.
At the time of the alleged oral agreement, Digipac had a bare-bones, two-page LLC agreement (read here) naming Tao as its sole member and manager. The LLC agreement stated that it could be amended “only in a writing signed by the Sole Member.” The court record contains no evidence that Behler saw a copy of the 2012 LLC agreement prior to the litigation, or that he inquired about its existence.
In 2014, Tao prepared and sent Behler a 29-page, unsigned Amended and Restated LLC Agreement of Digipac along with a Joinder Agreement and Subscription Agreement. The Amended LLC Agreement (read here) was set up for signature by Tao only as both Manager and Member. Behler never signed the Joinder Agreement or Subscription Agreement.
The Amended LLC Agreement contained a standard merger provision stating that it
constitutes the sole and entire agreement of the parties to this Agreement with respect to the subject matter contained herein and therein, and supersedes all prior and contemporaneous understandings, agreements, representations and warranties, both written and oral, with respect to such subject matter, including the Original [LLC] Agreement.
Remark's share price never approached $50 per share. At the five-year anniversary of Behler's investment in 2017, Remark's shares were trading at $9.15 per share which according to the alleged oral agreement entitled Behler to be bought out for about $11.6 million, which Tao allegedly failed to do despite acknowledging his breach of the oral agreement. (Currently, Remark's shares trade at $0.056/share.)
Behler sued Tao in New York state court for breach of the oral agreement. The Motion Court granted Tao's pre-answer motion to dismiss the complaint primarily on the ground that, as a member of the LLC, under Section 18-101[9] of Delaware's LLC Act (“A member or manager of a limited liability company . . . is bound by the [LLC] agreement whether or not the member or manager . . . executes the [LLC] agreement.”), Behler as a non-signatory nonetheless was bound by the original and Amended LLC Agreement including the latter's merger provision (read here).
On Behler's appeal to the Appellate Division, the majority agreed with the Motion Court that Behler was bound by the Amended LLC Agreement's merger provision, holding that “[b]ecause the amended LLC agreement and [oral agreement] both concern the liquidation and distribution of plaintiff's interest in Digipac, the amended LLC agreement, by virtue of the merger clause, supersedes the [oral agreement]” (read here).
The dissenters decried the majority's decision allowing the controller to “nullify” the alleged oral agreement between long-time friends “with total impunity” by unilaterally amending the LLC agreement to include a merger provision which “deprives his friend of all legal remedies . . . in violation of basic principles of contract law and fundamental fairness.”
Behler subsequently appealed as of right to the Court of Appeals.
The Court of Appeals Weighs In
The Majority Opinion
In the majority's opinion authored by Judge Singas, the Court of Appeals held that, upon his initial investment in Digipac, Behler “became bound by the original LLC agreement, including its clause dictating how its terms could be altered” and that once altered, “plaintiff became bound by the amended LLC agreement, including its merger clause.” In so ruling the opinion cited the above-quoted Section 18-101[9] of the Delaware LLC Act along with Section 18-1101[b] of the Act stating that “[i]t is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.”
The majority opinion rejected Behler's argument that the alleged exit opportunity agreement fell outside the Amended LLC Agreement's merger provision, explaining:
Because the oral agreement and amended LLC agreement involve the same subject matter, the amended LLC agreement superseded the oral agreement through the merger clause. The oral agreement concerns investment in Digipac, the liquidation of Digipac's assets and distribution of the proceeds, and the transfer of a Digipac membership interest. The amended LLC agreement contains provisions which govern all of those issues, in line with its express purpose “to provide for the . . . distributions among the Members” and “the rights, obligations and interests of the Members to each other and to the Company.” For example, the amended LLC agreement states that “a Member may only Transfer all or any part of its Membership Interest upon the written approval of the Manager, which may be withheld or conditioned for any reason.” Plainly, this provision concerns the same subject matter as defendant's promise to transfer plaintiff's membership interest on the fifth anniversary of plaintiff's initial investment.
Behler's additional arguments gained no traction with the majority. The majority disagreed with Behler's contention that the merger provision doesn't apply because Tao entered into the oral agreement in his personal capacity rather than in his corporate capacity. The majority cited a number of allegations in Behler's complaint that it characterized as inconsistent with the argument, including that Tao “agreed that if the price of Remark were to hit $50/share, he would cause Digipac to sell its shares of Remark and distribute the proceeds” to Behler (italics in original).
The majority also rejected Behler's argument against enforcement of the merger provision on the basis that he was a party to the oral agreement in his personal capacity, but a party to the Amended LLC Agreement in his member capacity. On that point Judge Singas responded, “[t]he consideration plaintiff received from the oral agreement was, in part, a guaranteed exit from his Digipac membership, which implicates, and in fact assumes, plaintiff's role as a Digipac member.”
To this observer, the most interesting part of Judge Singas' majority opinion is its finale where he acknowledges the apparent “harsh” outcome of the court's ruling, yet chides Behler for not undertaking adequate diligence before making his investment in Digipac, writing:
Though an outcome whereby one member to a contract unilaterally extinguishes his contractual obligation, even after the other party has performed, may appear “harsh,” the Appellate Division correctly observed that Delaware law “unambiguously advises prospective investors in a closely held LLC (especially one considering a multimillion-dollar investment) to scrutinize the existing LLC agreement and condition their investment upon the clear written delineation thereunder of . . . their contracted-for rights in the event of any future amendments to the LLC agreement” (Behler, 227 AD3d at 126). Despite his reservations about investing in an LLC, plaintiff, who admits to having some business experience, failed to take the appropriate measures to protect the terms of the oral agreement from defendant's explicit unilateral authority to amend the LLC agreement. Indeed, the amended LLC agreement contains multiple provisions that carve out special rights for a different Digipac member.
The Dissent
Out the outset of her opinion for the three dissenters, Judge Rivera leaves little doubt that, like the Appellate Division dissenters, she views the outcome of the majority's ruling as fundamentally unfair, not necessarily in a moral sense but, rather, contractually. Here's what she writes in her opening paragraph:
In 2012, plaintiff and defendant entered into an agreement to give plaintiff an exit opportunity from defendant's limited liability company in exchange for a $3 million investment. Defendant thereafter took plaintiff's money, accepted him as a member of the LLC, and met with him regularly to discuss his investment. For six years, defendant did not deny that the exit opportunity existed and, when plaintiff sought its performance, defendant freely acknowledged his obligations under the agreement. Yet the majority now invokes the merger clause of an entirely different agreement to allow defendant to avoid his obligation to plaintiff. This outcome is contrary to fundamental principles of contract interpretation. I dissent.
According to Judge Rivera, the exit opportunity agreement and the Amended LLC Agreement “do not concern the same subject matter.” The former, she writes, was an “agreement reached between two friends . . . to induce plaintiff to invest in defendant's company by protecting his investment and affording him a way out following the occurrence of certain events.” The latter, she continues, “is Digipac's governing instrument, adopted years after plaintiff's investment, which was intended to manage Digipac's internal affairs and direct the conduct of its business.” Ergo, the latter's merger provision does not apply to the former.
Judge Rivera's opinion also argues that the two agreements “involve different parties, exercising different roles,” as reflected in the complaint's allegations that “defendant negotiated with plaintiff as an individual, promised him an exit opportunity as an individual, and is liable to plaintiff for breaching that promise as an individual.”
Judge Rivera concludes her dissent emphasizing what she sees as the disjuncture between the alleged exit opportunity agreement and the Amended LLC Agreement with its merger provision:
In sum, this dispute concerns a personal agreement between two business partners and friends. Because one of those friends did not live up to his promise, the other now seeks to enforce it against him alone. That effort simply has nothing to do with Digipac's relationship with its members or the “clarity and certainty” (majority op at 9) that they should expect in dealing with Digipac. Rather, the majority disrupts the certainty of our well-established motion practice standards by recasting the allegations of the complaint to refashion the parties' promise into a corporate commitment. At the very least, plaintiff's contentions raise ambiguities in the exit opportunity agreement that cannot be resolved on a motion to dismiss. The majority ignores these ambiguities and cuts this case short at the outset, leaving defendant with $3 million of plaintiff's money and plaintiff without recourse. Because Delaware law and this State's liberal CPLR 3211 standard require otherwise, I would reverse the Appellate Division order and remit for further proceedings below. [Citations and footnote omitted.]
For readers wishing to take a deeper dive, you can access Behler's opening brief here, Tao's opposing brief here, Behler's reply brief here, and the transcript of oral argument in the Court of Appeals here.
Whether It's a Delaware or New York LLC, Look Before You Leap
I quoted above Section 18-101(9) of Delaware's LLC Act, binding a member to the LLC agreement whether or not the member signs it. While New York's LLC Law does not have a provision of similar clarity or breadth, the default rule found in Section 402(c)(3) provides that a majority in interest of the members may “adopt, amend, restate or revoke the articles of organization or operating agreement.” Whether the New York default rule à la Behler binds automatically a member who acquires a membership interest in a pre-existing LLC to the terms of a pre-existing LLC agreement, is not a question I've seen addressed in any New York caselaw.
Regardless of any differences between Delaware or New York law, for anyone contemplating becoming a non-controlling member of an existing LLC, it is imperative that they do exactly what both the Appellate Division and Court of Appeals majority opinions advise: “scrutinize the existing LLC agreement and condition their investment upon the clear written delineation thereunder of . . . their contracted-for rights in the event of any future amendments to the LLC agreement.”
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
