In Tzolis v. Wolff, 2008 WL 382345 (N.Y. Feb. 14, 2008), a majority of the New York State Court of Appeals held, over a vigorous dissent, that New York law permitted members of a limited liability company (“LLC”) to bring derivative suit on the LLC’s behalf.  As a result, under New York law, the right to bring a derivative suit has been broadened, and is no longer limited to shareholders of a corporation or limited partners of a partnership.  This ruling represents the third decision in just one week by a state’s highest court addressing the scope of legal standing for plaintiffs in shareholder derivative suits.  (We previously reported on decisions by the Delaware Supreme Court and California Supreme Court.)

The facts in Tzolis were undisputed.  Plaintiffs held a 25% interest in Pennington Property, an LLC.  Plaintiffs alleged, both individually and derivatively, that “those in control of the LLC, and others acting in concert with them, arranged first to lease and then to sell the LLC’s principal asset for sums below market value; that the lease was unlawfully assigned; and that company fiduciaries benefited from the sale.”  The trial court dismissed plaintiffs’ claims holding that they lacked standing to sue as individuals because the claims belonged to the LLC, and that the plaintiffs could not sue derivatively because New York’s “Limited Liability Company Law” did not expressly authorize derivative suits on behalf of LLCs.  The intermediate appellate court reversed, concluding that derivative suits on behalf of LLCs are permitted, and granted permission to appeal to New York’s highest court, the Court of Appeals.

The Court of Appeals concluded that such derivative suits were allowed and rested its decision on two grounds.  First, the Court noted the general importance of derivative suits and the fact that these suits are judicially created remedies.  Second, the Court noted that the “absence of evidence that the [New York] Legislature decided to abolish” the derivative suit as a remedy for management malfeasance at LLCs suggested that the Court had license to craft a remedy to combat “faithless fiduciaries” of LLCs.

The Court first examined the history of the derivative suit generally.  It noted that this remedy was “not created by statute, but by case law.”  The Court noted that this same principle drove the Second Circuit to a similar conclusion when it held that limited partners could sue on a partnership’s behalf.  Noting that “the Legislature obviously did not intend to give corporate fiduciaries a license to steal,” the court held that public policy supported allowing LLC derivative lawsuits.

Second, the Court noted the absence of any language in the Limited Liability Company Law that spoke either for or against allowing derivative suits against LLCs.  The Court noted that “it could hardly be argued that the mere absence of authorizing language in the Limited Liability Company Law bars the courts from entertaining derivative suits by LLC.”  The Court held that the legislative history was “far too ambiguous to permit us to infer that the Legislature intended wholly to eliminate . . . a basic, centuries-old protection for shareholders, leaving the courts to devise some new remedy.”  In light of its public policy concerns about “faithless fiduciaries” run amok, and its conclusion that the Legislature had not manifested any intent to eliminate LLC derivative suits when it had failed to explicitly provide for such a remedy, the Court concluded that Plaintiff could proceed derivatively.

In dissent, Judge Susan P. Read strenuously objected to the Court’s holding, calling the result “unique in the annals of the Court of Appeals.”  In particular, Judge Read argued that the majority had “read into” the Limited Liability Company Law a “policy choice[]” that the New York Legislature had explicitly “considered and rejected.”  Examining the legislative history, Judge Read noted that the bill to create the Limited Liability Company Law was part of an effort to combat a business environment that was seen as “unfriendly to fledgling businesses” and to make New York more “pro-business.”

The Limited Liability Company Law initially languished in limbo between the Assembly and Senate.  Only after the Assembly introduced a version of the Bill that did not authorize LLC derivative suits was the stalemate broken.  Judge Read argued, this was the compromise reached by the Legislature:  “exclusion of provisions authorizing derivative actions from the Assembly bill in exchange for the Senate’s agreement to the balance of the law.”  Consequently, Judge Read concluded that, on the basis “judicial fiat” the majority had created a right “unfettered by the prudential safeguards against abuse” that had been “rejected by the Legislature, and, for more than a decade after the Limited Liability Company Law’s enactment, was not recognized by any New York court.”

In contrast to the decisions recently handed down by the California and Delaware Supreme Courts, Tzolis broadens the standing requirement to allow individual members of an LLC to bring suit against that same LLC “on behalf of” that same LLC.  Moreover, by broadening New York law to allow derivative lawsuits against LLCs, New York courts have signaled a greater willingness to potentially expand the derivative suit to other corporate formations.

For further information, please contact John Stigi at (213) 617-5589.