Non-Managing Members Of An Llc Do Not Owe A Fiduciary Duty To The Llc And The Other Llc Members

• Posted on: Feb 17 2017

In this Blog’s last entry, we discussed the advantages and disadvantages of forming a limited liability company (“LLC”). Today’s entry discusses whether non-managing members of a manager-managed LLC owe fiduciary duties to the other LLC members and to the LLC itself.

An LLC is a hybrid business entity having the attributes of both a corporation and a partnership. E.g., Willoughby Rehabilitation & Health Care Ctr., LLC v. Webster, 2006 NY Slip Op. 52067(U) (13 Misc. 3d 1230(A)), at 3-4 (Sup. Ct. Nassau Co. Oct. 26, 2006). Its owners are its members. Limited Liability Company Law § 417(a) provides that the members of an LLC “shall adopt a written operating agreement relating to the business of the company, the conduct of its affairs and the rights and powers of its members.” The operating agreement is, therefore, the primary document defining the rights of members, the duties of managers and the financial arrangements of the limited liability company. Id. at 3 (citing Rich, Practice Commentaries, 32A Limited Liability Company Law Section 1.A, p. 4 (McKinney’s, 2006); and Lio v. Mingyi Zhong, 10 Misc 3d 1068(A) (Sup. Ct. N.Y. Co. 2006)).

Pursuant to Limited Liability Company Law § 409, “a manager shall perform his or her duties as a manager … in good faith and with a degree of care that an ordinary prudent person in a like position would use under similar circumstances.” The acts of working in concert and managing a limited liability company gives rise to a relationship among the members which is analogous to that of partners who, as fiduciaries of one another, owe a duty of undivided loyalty to the partnership’s interests. Id. at 3-4 (citing Birnbaum v. Birnbaum, 73 N.Y.2d 461, 466, rearg. denied, 74 N.Y.2d 843 (1989), and Meinhard v. Salmon, 249 N.Y. 458, 463-64 (1928)).

A partner, and by analogy, a member of a limited liability company, has a fiduciary obligation to others in the partnership or limited liability company which bars not only blatant self-dealing, but also requires avoidance of situations in which the fiduciary’s personal interest might possibly conflict with the interests of those to whom the fiduciary owes a duty of loyalty. Id. at 4 (citing Salm v Feldstein, 20 A.D.3d 469, 470 (2d Dept. 2005); Nathanson v. Nathanson, 20 A.D.3d 403, 404 (2d Dept. 2005)).

Consequently, based upon the foregoing analysis, New York courts have held that a managing member of a manager-managed LLC has a fiduciary duty to the other members of the LLC.

However, while the managing member of a manager-managed LLC owes a fiduciary duty to the non-managing members, non-managing members do not owe a fiduciary duty to each other or to the LLC.  The reason, say the courts, is the absence of a duty imposed on the non-managing members to act in good faith and with due care under Section 409 of the Limited Liability Company Law. Kalikow v. Shalik, 43 Misc. 3d 817, 826 (Sup. Ct. Nassau Co. Feb. 26, 2014).

Last month, these principles were addressed by Justice Anil Singh of the Supreme Court, New York County in Landes v. Provident Realty Partners II, L.P., 2017 NY Slip Op. 30196(U) (Sup. Ct. N.Y. Co. Jan. 31, 2017).

Background:

The action involved the relationship between several limited partnerships and limited liability companies holding indirect interests in real property.

The plaintiffs are limited partners of Provident Realty Partners II, L.P. (“PRP II LP”), a New York limited partnership that was formed to, among other things, acquire, develop, manage, operate and transfer real property. PRP II Corp. is the general partner of PRP II LP. Pursuant to PRP II LP’s Limited Partnership Agreement, PRP II Corp. had a “fiduciary responsibility” to PRP II LP “for the safekeeping and use of all assets of PRP II LP” and was prohibited from “tak[ing] or permit[ting] another to take any action with respect to the assets of the Partnership which action is not for the benefit of the Partnership.” Defendant Daniel Benedict (“Benedict”) is the President and sole shareholder of PRP II Corp.

On or about March 28, 2007, IMICO UN (“IMICO”) joined PRP II LP in a partnership relating to property at 303 East 46 Street, New York, New York (“the Property”). In furtherance of that venture, IMICO and PRP II LP formed 303 BRG-IMICO LLC (“303 LLC”), whose express purpose was to “acquire . . . own, hold, improve, develop, manage, insure and operate” the Property. PRP II LP is the Managing Member of 303 LLC and holds a 50% percentage membership interest in the company.  IMICO, a Delaware corporation authorized to do business in the State of New York, is the other 50% member.

Pursuant to 303 LLC’s operating agreement, IMICO was prohibited from “assign[ing], pledg[ing], hypothecat[ing], transfer[ing] or otherwise dispos[ing] of all or any part of [its] interest in the Company, including, without limitation, the capital, profits or distributions of the Company without the prior written consent of [PRP II LP] as well as Members holding at least sixty-five (65%) of the Member’s [sic] Percentage Interest.”

In September 2011, IMICO sold a 49.9% membership interest in 303 LLC to BRG Gramercy Units LLC (“BRG Gramercy”), a company that was owned and controlled by Benedict, for approximately $499,900 (the “Transaction”). According to the plaintiffs, the Transaction could not be effectuated without PRP II LP’s consent. The plaintiffs also maintained that IMICO’s interest in 303 LLC was illiquid but had full value to Benedict – and would have had full value to PRP LP II – since along with Benedict’s position as general partner of PRP II LP, it provided him with 100% beneficial ownership of 303 LLC and unfettered control over its affairs.

In February 2013, Benedict advised the plaintiffs of the Transaction. The plaintiffs claimed that the Transaction was effected surreptitiously, without advice to, consultation with or consent of the limited partners of PRP II LP.

On or about December 12, 2012, 303 LLC sold the Property for $4,100,000. The plaintiffs claimed that Benedict profited from his purchase of IMICO’s membership interest, effectively realizing in excess of approximately $600,000 from the sale of the building – which profit, claimed the plaintiffs, belonged to PRP II LP. Thereafter, Benedict caused the proceeds from the sale to be invested in BRG Office LLC (“BRG Office”) in a 1031 Tax Exchange Transaction involving the purchase of a 118,000-square foot medical office building located at 711 Stewart Avenue, Garden City, New York (“711 Stewart”). The limited partners of PRP II LP were not provided with any information or documentation concerning the ownership structure of BRG Office or the terms and details of its investment in 711 Stewart, even though PRP LP II owns 50% of 303 LLC which, in turn, owns BRG Office.

The plaintiffs commenced the action as a derivative action, alleging: (a) breach of contract and breach of fiduciary duty against PRP II LP and Benedict; (b) aiding and abetting a breach of fiduciary duty against BRG Gramercy and IMICO; (c) the misappropriation of a business opportunity against all defendants; (d) unjust enrichment against PRP II Corp. and Benedict; (e) constructive trust against BRG Gramercy; and (f) an accounting.

Each side moved for summary judgment.

The Court’s Ruling:

On the issue of whether a non-managing member of a manager-managed LLC owes a fiduciary duty to the other members of the LLC and to the LLC itself, the court declined to impose one.  The Court’s ruling was made in connection with the claim that IMICO and BRG Gramercy aided and abetted the breach of fiduciary duty by Benedict.

In concluding that IMICO did not provide substantial assistance to Benedict and PRP II LP, the Court noted that IMICO’s alleged inaction was sufficient to satisfy that prong of the claim only if Benedict owed a fiduciary duty to PRP II LP.  The Court found that IMICO, as a 50% non-managing member of the LLC, did not owe a fiduciary duty to PRP II LP, the managing member.

In so finding, the Court followed the reasoning in Kalikow v. Shalik, 43 Misc.3d 817 (Sup.Ct. Nassau Co. Feb. 26, 2014), and held that non-managing members of LLCs do not owe fiduciary duties to the LLC or its managing member:

A non-managing member of an LLC who has a 50% interest in the LLC, such as IMICO does not owe a fiduciary duty to a managing member of the LLC or directly to the LLC. Although not binding, the court’s ruling in Kalikow v. Shalik, 43 Misc.3d 817 (Sup.Ct. Nassau Co. Feb. 26, 2014), is persuasive. In Kalikow, two sole members of an LLC had a 50% interest, with only one of the members identified as the managing member. The court held that based upon the language of New York L.L.C. Law § 409, and the absence of language related to the duty of good faith or loyalty on behalf of a non-managing member of an LLC, that non-managing members do not owe a fiduciary duty to managing members of the LLC or to the LLC itself.

Accordingly, because the plaintiffs could not show that IMICO gave substantial assistance to a breach of fiduciary duty, the Court denied the plaintiffs’ motion for summary judgment and granted IMICO’s motion for the same relief.

Takeaway:

Landes is significant because, in the absence of appellate authority, it confirms the view that a non-managing member of a manager-managed LLC does not owe a fiduciary duty to the other members and to the LLC itself. This Blog will continue to watch for cases and authority that address this important issue.

Tagged with: Business Law, Business Litigation