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“Retaliatory Amendment” of an LLC Operating Agreement

LLCs are celebrated for allowing business partners to freely define their relationship by contract — i.e., the LLC operating agreement.  The operating agreement generally covers all of the important aspects of the company and the relationship between the LLC’s members and manager(s), including ownership interests, capital contribution requirements, rights to distributions, and managerial authority.

Like all contracts, operating agreements can be amended and modified.

A recent opinion from the Supreme Court of New York — Yu v. Guard Hill Estates, LLC — illustrates how the process of amending an LLC’s operating agreement can sometimes be used to gain the upper hand in a dispute between members.

Facts: majority of members amend operating agreement to remove manager and escalate capital calls

According to the complaint filed by Patrick Yu, the case was based on the following facts:

Patrick Yu, Raymond Yu, and Catherine Yu were siblings with shared ownership interests in two LLCs (Guard Hill Estates, LLC and 33 East 38th Street, LLC), each of which owned property in New York.  The LLCs were created for the Yus’ parents to transition ownership of the properties to their children.

Under the operating agreement for each LLC, Patrick was the managing member.  No changes had been made to the LLCs’ operating agreements for more than ten years.

A family dispute arose between Patrick on one hand on his parents and siblings on the other.  Patrick alleged that in retaliation against him, his siblings embarked on the following course of conduct:

  • In July 2015, they amended the LLCs’ operating agreements to remove Patrick as managing member of both LLCs, without notice or explanation.
  • In January 2016, they further amended the LLCs’ operating agreements to add a provision stating that the new managers (Raymond and Catherine) could demand capital contributions from all members, and if such contributions were not made by a member, that member’s interest in the LLC could be foreclosed.
  • In September 2016, they made a capital call in the amount of $590,887 from each member, for the purpose of reimbursing the parents for some renovations and paying off the mortgage on the property.  Patrick alleged the siblings made this capital call knowing that Patrick was financially unable to make the payment.

Raymond and Catherine made their capital call payments.  Patrick did not, and he received a letter notifying him that he was in default and his ownership interests were in jeopardy of foreclosure.

Patrick sued for dissolution of the LLCs under New York law, claiming that the LLCs were no longer carrying on business as intended under the operating agreement, and that the continued operation of the LLCs had become financially unfeasible.  Patrick claimed that the LLCs were instead being used as “weapons” to oppress him.

Raymond and Catherine filed a motion to dismiss Patrick’s complaint.

Court’s Holding: amendment of the operating agreement was proper; case dismissed

The court granted the motion and dismissed Patrick’s claims.

The court observed the broad language in the operating agreements defining the purpose of the LLCs.  Both of the agreements defined the purpose of the entity using open-ended language: essentially, owning and operating property, and “engaging in any and all activities necessary or incidental to the foregoing.”

Given that broad language, the court held, Patrick failed to plead adequate grounds for dissolution in his complaint.

The court held:

While Patrick complains that his family members have been engaged in certain activities to further their personal “vendetta” against him, his unflattering characterization of his family’s actions is not sufficient to support a cause of action that his family has abandoned the purpose of the LLCs and/or rendered the operation of the LLCs financially unfeasible.

As such, Patrick’s allegations of an unfair, retaliatory amendment of the operating agreement was not enough to state a claim for dissolution.  The amendments didn’t render the LLCs insolvent or incapable of fulfilling their purpose.

Lesson

The “freedom of contract” foundation that makes LLCs such an attractive form of business entity also carries some risks.  Parties will be held to the language they select for their operating agreement.

If the operating agreement allows for amendment or other changes (including those affecting managerial control, contribution requirements, etc.) by simple majority vote, then the will of the majority will generally be enforced.  Even if such amendments are pursued with less than pure objectives, if they do not render the LLC unable to carry on its stated purpose they will probably not provide grounds for judicial dissolution of the LLC.

Keep in mind, however, that Patrick apparently only sued for dissolution.  While his allegations were not enough to fulfill the statutory requirements for dissolution, he might have been able to state a claim for breach of fiduciary duty or breach of the covenant of good faith and fair dealing, especially if the case was governed by California law.  As covered in a recent post — LLC Distributions, Charging Orders, and Manager Fiduciary Duties — even discretionary conduct can sometimes run afoul of the covenant of good faith and fair dealing.

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