[Shareholder Oppression] New York Derivative/LLC case
Eric Fryar
Bartfield v. Murphy, 578 F.Supp.2d 638 (S.D.N.Y. Sep 29, 2008).
The United States District Court for the Southern District of New York has delivered an opinion that highlights several important procedural issues having to do with LLCs and derivative suits. This case involved a New York LLC that had two members, each with 50% ownership, and who had agreed to participate equally in management. The business involved underwriting medical stop-loss insurance policies. The breakdown in the relationship came over a series of business missteps that one of the members attributed solely to the other, which hurt the company financially and ultimately lead to a complete breakdown between the members. The Plaintiff was a citizen of Florida. The Defendant was a citizen of New York. The Plaintiff sued the Defendant individually in New York federal Court and did not name the LLC as a party.
The issue confronting the Court was whether it had subject matter jurisdiction. (It should be noted that it appears the Court raised this issue sua sponte and that the Defendant was content with proceeding in federal Court.) Jurisdiction was based solely on diversity, and the two members of the LLC had diverse citizenship. However, LLCs (unlike corporations) have the citizenship of each of their members. 578 F.Supp.2d at 644; Bischoff v. Boar's Head Provisions Co., 436 F.Supp.2d 626, 634 (S.D.N.Y. 2006); Carden v. Arkoma Assoc., 494 U.S. 185, 195-96, 110 S.Ct. 1015, 108 L.Ed.2d 157 (1990) ("[C]itizenship of an artificial entity ... in a suit by or against the entity depends on the citizenship of 'all the members,' 'the several persons composing such association,' [or] 'each of its members.' "). Therefore, the LLC was a citizen of both New York and Florida and could not be joined as a party, as joinder would destroy diversity.
The question of whether the LLC was required to be joined depended on whether the Plaintiff's claims were direct or derivative. The Court noted that the New York Court of Appeals had only recently resolved a split among the lower Courts, holding that a member of an LLC has standing to sue derivatively on behalf of the company. 578 F.Supp.2d at 646, citing Tzolis v. Wolff, 10 N.Y.3d 100, 105-106, 855 N.Y.S.2d 6, 884 N.E.2d 1005 (2008). Under New York law, an individual only has standing to bring suit when a wrongful act injures a legal right or property interest he holds. See, e.g., Warth v. Seldin, 422 U.S. 490, 500-01, 95 S.Ct. 2197, 45 L.Ed.2d 343 (1975). However, a shareholder in a corporation or a member and an LLC may bring a derivative claim on behalf the entity. When a derivative claim is brought, the entity is an indispensable party. 578 F.Supp.2d at 645. New York law follows the "direct injury test" to determine if a claim must be raised derivatively. Id. at 645. The issue is whether the "primary injury" for which relief is sought directly affects an interest the Plaintiff holds, or if it injures the legal entity's interests, which then derivatively injures the Plaintiff. See, e.g. Excimer Assocs. v. LCA Vision, Inc., 292 F.3d 134, 139-140 (2d Cir. 2002). ("[T]he critical question posed by the direct injury test is whether the damages a Plaintiff sustains are derivative of an injury to a third party. If so, then the injury is indirect; if not, it is direct."); Lenz ex rel. Naples Tennis Resort, 833 F.Supp. 362, 379-80 (S.D.N.Y. 1993) ("[T]he determination of whether a suit is derivative or direct turns on the nature of the injury alleged and the entity which sustains the harm.").
The Plaintiff alleged thirteen breaches of fiduciary duties, which he contended were individual claims rather than derivative claims. Almost all of these claims had to do where poor business decisions that damaged the company financially or destroyed the company's "book of business" and thus injured Plaintiff's "direct, indirect, or residual interest" in the Company's "book of business and/or its benefits." The Plaintiff also alleged claims for misappropriation of the company's assets, which the Plaintiff argued were direct claims since the misappropriation interfered with his individual ability to benefit from those assets. The Court held that all these claims were derivative. Id. at 647-48. The assets that were misappropriated belonged to the company; the business that was damaged was the business of the company. Plaintiff suffered only as a result of his ownership interest in the company. The Plaintiff also claimed that the Defendant had violated his individual rights by assuming control of the company and excluding the Plaintiff from his right of management. The Court acknowledged that this could be an individual claim, but the only damages alleged to result from this violation of the Plaintiff's individual rights was harm to the company. Plaintiff also alleged that there was a failure to disclose. This claim is a little more complex because there is an individual duty to disclose as between members of an LLC. Salm v. Feldstein, 20 A.D.3d 469, 470, 799 N.Y.S.2d 104 (2d Dep't 2005) (failure to disclose third party offer for LLC prior to Defendant member's purchase of Plaintiff's shares). However that duty to disclose is an individual duty only when it involves individual interests. For instance, a member would have a duty to disclose material facts to another member before buying or selling ownership units in the company. But the duty to disclose as to matters relating to be company's business, such as the existence of a corporate opportunity, is a duty that would be owed to the company – even though the duty in this case would be complied with by making disclosure to the other member. Because the pleadings did not state whether the failure to disclose involved a duty of disclosure to the company or a duty of disclosure to the Plaintiff, the Court ordered the Plaintiff to replead.
Because all of the Plaintiff's claims, with one possible exception, were claims belonging to the company, the Court held that the LLC was an indispensable party. The Court also held that the LLC was an indispensable party on the Plaintiff's declaratory judgment claims because the rights and interests about which a declaratory judgment was sought belonged primarily to the company. Under rule 19, the Court was then required to determine whether the case must be dismissed. Based primarily on the fact that the Plaintiff had an adequate remedy in state court, the Court held that "equity and good faith preclude adjudicating the derivative claims among the existing parties." 578 F.Supp2d at 650. Therefore, the Court dismissed all claims except failure to disclose claim, and ordered the Plaintiff to replead that claim. As the Court related the facts of the case, it seems highly unlikely that the Plaintiff's failure to disclose claim could relate to anything other than a matter about which the duty to disclose ran only to the company.
The rule that a corporation or LLC is an indispensable party in a derivative suit is one that tends to be strictly followed by the Courts. It must be admitted, however, that this rule in many cases is really one of form over substance. In this case, there were only two owners. 100% of the ownership interests were parties to the case. If the Plaintiff recovers on behalf of a company on the derivative claims, as a practical matter, he would be the only party receiving the benefit of the judgment. No other absent parties' interests were at risk. The Court states: "CFE [the company] may wish to contend that Murphy should pay more than Bartfield demands or that it has other obligations that should be evaluated when determining what is due Bartfield. Unless joined, CFE would either be unable to make such arguments, or could only do so in a separate lawsuit thereby exposing Defendants to a risk of subsequent, inconsistent obligations. As the requested judgment would directly determine the rights of CFE, the Court finds that CFE has an interest sufficient to require joinder and would suffer prejudice if not joined." While these statements would undoubtedly be true in a case where there were other non-party shareholders or members, it is most certainly not true in this case. Apart from one or both of the members, the company in this case would not have the ability to make any such assertion. If the Plaintiff recovered in this case, the Plaintiff would certainly be precluded from causing the company thereafter to bring another claim against the Defendant. Any third party that bought the company would also be precluded from doing a claim against the Defendant under the Bangor Punta doctrine. See Banfor Punta Operaations, Inc. v. Bangor & A.R. Co., 417 U.S. 703, 94 S.Ct. 2578 (1974).
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Posted By Eric Fryar to Shareholder Oppression at 12/09/2008 11:52:00 AM