Unincorporated Business Entities Law

As mentioned in my earlier post on the Casavecchia v. Mizrahi series of cases, the essence of the Casavecchia’s claims was that

1. the LLC had been formed to develop a single real estate development, Hills of the Heartland,
2. the development had been completed, and all units sold, and
3. instead of distributing profits, the Mizrahi had instead loaned the LLC’s funds to another LLC in which the Casavecchias were not participating.

I have already noted the disconnect between the Casavecchia’s understanding of the parties’ prior practice–one development at a time, and the formation of a new vehicle for new projects–and the breadth of the purpose provision of the LLC’s Operating Agreement. 

But here are other puzzling aspects of the trial court’s original order, Cassavecchia v. Mizrahi, No. 008635/2005 (N.Y. Sup. Ct. August 23, 2006) (Warshawsky, J.).  At first, it seemed as though Justice Warshawsky had ordered a defacto dissolution of the LLC.  In this connection, note that Section 701 only allows voluntary dissolution without a vote of the members only when the organizational documents provide for a time for dissolution, or dissolution on the happening of a specified event.  Section 702 of the New York Limited Liability Company Law allows for judicial dissolution at the request of a member "whenever it is not reasonably practicable to carry on the  business in conformity with the articles of  organization or operating agreement."  To the extent Warshawsky found a limited purpose, he could have found a voluntary dissolution under Section 701 or, perhaps that it was "not longer reasonably practicable" a purpose that had been completed.  But that’s not what the order said.

On closer reading, Warshawsky casts the issue as

The issue that emerges for determination is whether a reading of  ¶ 8,together with ¶¶ 4, 6 and 9 leads to the conclusion that profits of the Hills of Heartland venture should be allocated and distributed to the shareholders so that they have the right to control their use. See e.g. LLCL § 507, Interim Distributions.

Slip Op., at 3 (emphasis added).  Section 4 of the Operating Agreement set forth a broad, rather than a narrow, purpose of the LLC.  Id. at 2.  Section 6 provides for management by action of a majority in interest, which itself is consistent with the early statement that Mizrahi managed the day-to-day affairs of the LLC.  Id.  Section 9 provides for distributions "at the times and in the amounts determined by a majority in interest".  Id.  Section 507 of the New York LLC Law provides for interim distributions to members

to the extent and at the times or upon the happening of events specified in the operating agreement….

Section 8 of the operating agreement provides for the allocation of profits and losses to the members.  Slip Op., at 3.  Warshawsky then noted the dispute as to the purpose of the LLC, and concluded

While it is conceivable that [LLC] could build homes and lend money out of profits so generated, that plan of operating would have to be approved by all the investors in the venture as they are the lawful beneficiaries of the success of any LLC.

Slip Op., at 4. (emphasis added).

It is clear that, while Warshawsky contemplates interim distributions, the basis for his order of "an inquest … to determine the profits available for distribution" is not entirely clear.  Does he deem that the Cassavecchias’ own a majority of interest, so can decide to make distributions?  Does he instead believe (wrongly) that allocations under Section 8 give the members the right to distributions?  Why else would he suggest that the diversion of profits into a loan would require the approval of all investors?

posted by Gary Rosin

The still on-going litigation arising out of Hills of Heartland LLC can help illuminate the role of a transactional lawyer.  The latest installments are two opinions out of the NY Appellate Court, 2nd department, Casavecchia v. Mizrahi, 2008 NY Slip Op 00938 & 2008 NY Slip Op. 00939 (NY AD [2nd] December 16, 2008).  The appellate opinions grow out of orders by Judge Warshawsky (N.Y. Sup. Ct., Nassau County) on August 23, 2006 and on September 11, 2007.  The point here is not to parse the opinion, but to note the inconsistency between the LLC’s operating agreement and the practice of the parties.

Casavecchia and Mizrahi were serial real estate developers who

were in business together for many years constructing and marketing residential housing of which Hills of Heartland is just one. Allegedly, as a development was completed , the profits were used to finance the building of a new development. There came a time when plaintiff was no longer associated with the business.

Order, September 11, 2007, at 2.  One of the key disputes between Casavecchia and Mizrahi related to the role (and purpose) of Hills of Heartland LLC.  In the Order of August 26, 2006, Judge Warshawsky found that the purpose of Hills of Heartland LLC was solely to develop Hills of Heartland: 

Defendant bootstraps section 202(f) & (c) of the LLC on to the Hills of Heartland Operating Agreement to support the claim that the purpose of the Company was to build and to lend money. He unfolds a rather convoluted claim that plaintiff was interested in the Company lending money rather than distributing it when the Company acquired a parcel of land on which it has now completed development….   * * *  His profound ending is that the process of lending retained money rather making a distribution to investors is a sage and efficacious way of doing new business with old money.

* * *  The only dispute in the arguments of the parties … is whether the Company was formed to lend money. 

Despite thoroughly and carefully searching the record the court can find no evidence that it was.  Defendant’s assertion is unsupported by evidentiary proof in admissable form …. He testified that the Company had not made any loan. He admitted in the answer that it was formed to build homes.

Id. at 4. 

Mizrahi’s attorney appears to have focused on Section 202(f) of the New York Limited Liability Company Law, which includes in the laundry list of general powers of an LLC the power to "lend  money for any lawful purpose, invest or reinvest its funds…."  Earlier in the opinion, Judge Warshawsky had quoted paragraph 4 of the LLC’s Operating Agreement, which included an omnibus purpose clause:

4.  PURPOSE. The Company is formed for the purpose of acquiring, owning, operating, developing, constructing buildings of all kinds or nature and selling real estate and engaging in any lawful act or activity for which limited liability companies may be formed under the LLCL and engaging in any and all activities necessary or incidental to the foregoing.

Order of August 26, 2006, at 2 (emphasis added). 

The point here is not to assess Judge Warshawsky’s conclusion, could well have been influenced by the fact that he loaned the LLC’s funds to a company in which the Casavecchia’s had no ownership interest:

that defendant Mizrahi is the only investor in the Company who is actively involved in Casa Mason, the proposal of being an unsecured, unguaranteed, interest free lender to a Mizrahi entity appears to be a bountiful bonanza to only defendant.

Id. at 5.

Instead, assuming that the parties’ prior practice had been to invest in particular development projects via project-related unincorporated business entities (UBEs), why did the purpose clause not only refer to investment in real estate generally, but also include an omnibus purpose clause?  Surely, some transactional dropped the ball here, probably by trying to save drafting time by pulling out a form. 

There is more that I could say, but I’ll stop here.

posted by Gary Rosin

Revised 01/05/2009

The recent opinion in Faulkner v. Kornman (In re The Heritage Organization, L.L.C.), Adv. Proc. No. 06-3377-BJH (Banker. N.D. Tex. Dec. 12, 2008), raises an interesting question.  The underlying Operating Agreement provided that Heritage’s Manager owed no fiduciary duties of any sort to it or to its members.  Slip Op., at 29.  The trustee of the bankruptcy estate of Heritage asserted breach of fiduciary duties against the officers of Heritage’s Manager (also an LLC).  Although those officers may also have been officers of Heritage, this post will focus only the duties that they might have owed when acting as officers of the Manager.

Begin with two central principles.  First, an organization is separate from the persons that act on its behalf ("agents").  Although owners of the organization may not be liable for its obligations (assuming a limited liability form was used), the same is not true for its agents.  Agents can avoid liability on contracts entered into by them of behalf of the organization, but only if they fully disclose the the other party the identity of the organization, and that they are acting for it.  Agents remain fully responsible for any torts or crimes in which they participate.  The Nuremberg defense–I was just following orders (or acting for my organization)–does not wash.

The second principle is that organizations act only through human agents.  Those agents owe fiduciary duties to the organization, but generally owe only the usual duties to other persons–the duty to operate a car carefully, the duty not to defraud, or the duty not to murder (although Hollywood seems to think that duty is customary in large corporations!).

As I argued in Car gill & Statutory Preemption, the fiduciary obligations of persons that control a fiduciary derive from the fiduciary obligations of the controlled fiduciary.  To the extent that the controlled fiduciary (the manager of The Heritage Organization, L.L.C.) has procured a waiver of its fiduciary obligations (as in Section 6.03(A) of Heritage’s Operating Agreement), it should follow that the controlling fiduciary’s (the defendant’s in Faulkner) duties should follow that of the controlled fiduciary.  Thus, in Faulkner, a waiver of fiduciary duties of Heritage’s Manager should also extend to the managers and officers of that Manager.

Of course, it would be better to address that question in the Operating Agreement itself.  But then litigators would have less to do!

posted by Gary Rosin