Thursday March 20, 2008
THE DAILY RECORD
WESTERN NEW YORK’S SOURCE FOR LAW, REAL ESTATE, FINANCE AND GENERAL INTELLIGENCE SINCE 1908
Advocate’sVIEW
COA decision allows LLC members
to sue derivatively
By STEVEN E. COLE
Daily Record Columnist
At long last, the New York State Court of Appeals has decided an important issue that had resulted in a series of inconsistent decisions among the
lower state and federal courts: Does a member of a New York limited liability company (LLC) have standing to sue derivatively for wrongs committed
against the company?
In Tzolis v. Wolff, a divided Court of Appeals ruled that a LLC
member may assert such claims in the courts,__NY__; 2008 WL
382345 (Feb. 14). While the reasoning behind the decision may
be subject to debate, the Court of Appeals obviously recognized
the need for the issue to be resolved in a pragmatic way. The decision clearly defines the remedy available, but the Legislature’s
deliberate silence on this remedy means the process will be created through additional judicial precedent.
Both the majority and the dissent recognized that, in enacting
the New York Limited Liability Company Law (LLCL), the Legislature specifically considered adding a section providing for
derivative suits by members, and deleted that section. Indeed,
the dissent felt the majority “unwound the legislative bargain,”
which resulted in the passage of the law.
However, the majority saw the lack of an explicit remedy in the LLCL was
causing practical problems of jurisprudence, which required resolution. The
majority also noted the remedy of derivative actions was a product of the
common law, and the remedy pre-dated its statutory codification in other
statutes, such as the Business Corporation Law and the Partnership Law.
As in corporations and limited partnerships, those managing the LLC owe
fiduciary duties to the entity itself. These duties are different than any that
may be owed to the members of the LLC. If members may not sue derivatively on behalf of the LLC to enforce those duties, then plaintiffs may seek
to cast those duties as running to the members directly (as opposed to the
LLC).
Prior to the Tzolis decision, courts were faced with actions brought by LLC
members against other members alleging breach of fiduciary duties. The Court
of Appeals perceived that lower courts strained to hold fiduciaries accountable
for duties they owed to the LLC and its members, and that these decisions may
be “blurring” distinction between direct and derivative claims.
The court found it self-evident that “the Legislature obviously did not
intend to give corporate fiduciaries a license to steal” and, therefore, “a substitute remedy must be devised.” That remedy is a derivative action brought
by members on behalf of the LLC, in a fashion roughly similar to shareholders in a business corporation or limited partners in a limited partnership.
So what is the process? The Court of Appeals recognized that
the Business Corporation Law and Partnership Law built in safeguards against abuse of derivative lawsuits, which do not exist in
the LLCL, but also noted not all safeguards have come from the
Legislature. The Court of Appeals has largely left it to the courts
to determine what the process will be and what safeguards will be
enforced.
It is one thing to require that a member make a demand on
management before instituting a derivative action; a requirement
that has its origins in common law. It would seem to be quite
another to require plaintiffs to post security for costs, which is a
statutory invention.
May a successful plaintiff in a LLC derivative action recover
costs and attorneys’ fees from the company? That question alone
certainly will have practitioners researching the extent to which such remedy has origins in common law (it does). Ironically, the Legislature’s deliberate deletion allows the derivative action to proceed, and hands the process
entirely to the courts to oversee. Further, the courts must rely on venerable
— some would say outdated — precedent as a starting point for that oversight.
It would seem the best advice is to look to the provisions of the Business
Corporation Law as a roadmap, and be prepared for uncertain results.
The decision in Tzolis v. Wolff has placed lawyers and trial judges on the
front lines of LLC fiduciary duty battleground. It will be interesting to see
how closely the process for bringing derivative claims reflects (or doesn’t
reflect) the provisions of the proposed Limited Liability Law deleted by the
Legislature.
Steven E. Cole is a partner in the law firm of Leclair Korona Giordano Cole
LLP and concentrates his practice in the area of commercial and securities litigation.
Reprinted with permission of The Daily Record ©2008