The Operating Agreement Controls, Unless Public Policy Says Otherwise

Two principles often guide courts’ interpretation and enforcement of contracts.  First, courts respect parties’ freedom of contract, mostly.  So long as an agreement is not illegal or violative of a strong public policy, parties are free to create whatever deal they wish.  Second, the plain language of a written agreement is the best evidence of what the parties intended their deal to be.

In business divorce litigation, we see these principles at work in disputes over the enforcement of an LLC’s operating agreement.  And while they can be stated with disarming simplicity, rarely is their application quite as simple.

This week’s post considers a duo of recent decisions applying these contractual principles to hotly-contested disputes between LLC members over the terms of their operating agreement.  In the first case, the court considered whether to enforce an operating agreement as written despite evidence that the parties actually intended a different deal.  In the second, the court considered whether to enforce an operating agreement where its buyout terms were grossly unfair.  The cases’ different outcomes highlight the outer limits of the parties’ freedom of contract in LLC operating agreements.

YMSF

In the first case, YMSF Family Partnership v Beitel, Index No. 514791/2017, Brooklyn Commercial Division Justice Leon Ruchelsman granted summary judgment on the plaintiff’s claim for a declaratory judgment seeking to recognize his 49.9% membership interest in 5309 18th Ave Besatya LLC (“Besatya”), a limited liability company that owns real property in Brooklyn.

Plaintiff YMSF alleged that in September of 2013, YMSF agreed to purchase a 49.9% membership interest in Besatya for $800,000, which purchase is memorialized by an operating agreement signed by YMSF and Beitel—the 50.1% member—recognizing YMSF’s capital contribution and 49.9% interest in Besatya.  Years later, when Beitel refused to recognize YMSF’s interest in Besatya, YMSF commenced suit seeking a declaratory judgment establishing its ownership interest, access to the books and records of Besatya, and attorneys’ fees pursuant to the operating agreement.

Beitel argued that notwithstanding the operating agreement’s purporting to grant a 49.9% membership interest to YMSF, the parties actually intended their deal to be a mere loan from YMSF to Beitel.  But because Jewish law prohibited the parties from entering into an interest-bearing loan agreement, they designed their agreement as a Heter Iska—a series of interdependent agreements designed to circumvent the Jewish prohibition on interest-bearing loans among Jews by treating all loans as business ventures.  The operating agreement, Beitel argued, was never intended to actually convey to YMSF an ownership interest in Besatya; it was only part of the Heter Iska.

Justice Ruchelsman granted YMSF summary judgment on all three causes of action, holding that YMSF is a 49.9% member of Besatya, YMSF is entitled to inspect the books and records of Besatya, and YMSF is entitled to its attorneys’ fees.  Justice Ruchelsman relied on the unambiguous language of the operating agreement providing that (i) the purpose of the entity is engage “in any lawful act or activity for which limited liability companies may be formed under the LLCL and engaging in all activities necessary or incidental to the foregoing” and (ii) “the Membership interests and contributions of the Members as of the date hereof are as follows: Binyamin Beitel: 50.1%, YMSF Family Partnership L.P. 49.9%.”  It is well settled, the Court held, that “an agreement that is clear and unambiguous on its face shall be enforced according to its plain terms.”  Thus, YMSF was a 49.9% member of Besatya.

The Court rejected under the parol evidence rule—an evidentiary rule barring the introduction of evidence to alter the unambiguous terms of a contract—Beitel’s attempt to rely on the circumstances leading up to the execution of the operating agreement, including the parties’ consultation with a Rabbi regarding an appropriate Heter Iska: “it is not proper to utilize parol evidence in the religious context to establish the substance of a secular agreement.”

Thus, as between the plain language of the operating agreement and Beitel’s evidence that the parties actually intended a different deal, the operating agreement controls.

Atlantis Management

In the second case, Atlantis Management Group II LLC v Nabe, Index No. 651598/2017, Manhattan Commercial Division Justice Jennifer Schecter found that an LLC’s managing member breached the operating agreement by failing to provide the non-managing member with access to certain books and records, but refused to enforce the agreement’s buy-sell provision triggered by that breach.

Peter Mahler previously covered an earlier decision in Atlantis here.  To briefly summarize, Plaintiff Atlantis Management Group II (“Atlantis”) was an “investor member” in four LLCs, each of which operated a gasoline service station (the “Companies”).  The operating agreements for the Companies were substantially the same, and each provided for monthly distributions to the plaintiff based on monthly profits.  In 2012, a major competitor of the Companies closed, and Atlantis expected the profits to materially increase.  When monthly distributions did not change, Atlantis sought to inspect the Companies’ books and records.

Defendants refused Atlantis’ inspection demands, pointing to an alleged subsequent oral agreement that the parties made in 2011 whereby Atlantis agreed to accept a fixed sum of $10,000 each month, and in turn waived its right to seek financial information from the Companies.

In response, Atlantis gave Defendants notice that they were in breach of the operating agreements and that it was electing to purchase their interests in the Companies pursuant to the buy-sell provision of the operating agreements, triggered by Defendants’ breach.  Specifically, the buy-sell provision provided—in a provision separately initialed by each member—that “Breach of any provision of this Operating Agreement . . .” would trigger Atlantis’ buyout rights.  The provision continued:

If the Managing Members, jointly or individually, shall fail to perform any of the covenants . . . of this Operating Agreement, the investor Members shall have the right, jointly or individually, at the Investor Member’s election, and upon five (5) days written notice to cure to the Managing Members . . . . to Buy-Back all of the Membership Interests of the Managing Members in consideration for the sum of One ($1.00) Dollar U.S. . . .

When the Defendants refused to recognize the sale, Atlantis brought claims arising out of Defendants’ breach of the books and records provision of the operating agreements and Defendants’ refusal to honor the buy-sell provision of the operating agreements, which was triggered by the breach of the books and records provision.  Atlantis also brought a claim for breach of the operating agreements’ requirement to pay it monthly distributions based on profit.

Justice Schecter granted Atlantis summary judgment on its claim for breach of the books and records provision of the operating agreements.  “Despite the books and records breach or even any other provable breach,” however, the Court held that the plaintiff is not entitled to exercise its rights under the buy-sell provision to purchase defendants’ interest for $1 because it was a disproportionate penalty, unenforceable as a matter of public policy.  The Court observed:

Here, it is clear that the buy-back clauses—forfeiture for a dollar—are grossly disproportionate, unreasonable, unenforceable penalty provisions.  By their terms, any breach “of any provision” however trivial triggers the draconian $1-buy-out consequence without regard to the magnitude of the breach or actual value of the interest surrendered . . . Section 6.3 is conspicuously disproportionate to foreseeable losses . . .  because the same drastic remedy applies to an immaterial technical breach as it does a material one. By punishing any breach, however minor, with forfeiture of valuable interests in exchange for a mere dollar, the intent of the provision is purely punitive.

Thus, while Atlantis was able to establish that defendants had breached the operating agreements, the Court refused to enforce the $1.00 buyout provision in the operating agreement triggered by that breach.

The Court also denied Atlantis’ request for summary judgment on its claims regarding other alleged breaches of the operating agreements, finding issues of fact surrounding the alleged oral agreement where Atlantis allegedly agreed to accept a fixed monthly sum in exchange for a waiver of its inspection rights.

The Takeaway

These cases straddle the limits of the courts’ predisposition to enforce LLC operating agreements as written.  In YMSF, the Court chose to enforce the terms of the operating agreement despite a considerable body of evidence suggesting that the parties actually intended a different deal.  In Atlantis, by contrast, the Court refused to enforce the unambiguous terms of the operating agreement despite evidence that the parties—who separately initialed that provision—intended it to be enforced exactly as written.

The apparently conflicting outcomes in YMSF and Atlantis can be harmonized.  The Court’s decision in Atlantis was based on the strong public policy against disproportionate penalty provisions—a factor not at issue in YMSF.

Another interesting nuance joins these cases: the Court’s treatment of boilerplate merger and no-oral-modification clauses.  The operating agreements in Atlantis contained a broad merger and no-oral-modification clause (section 15.2), but that clause did not stop the Court from finding issues of fact stemming from a subsequent oral agreement that definitively altered the terms of the operating agreements.  In YMSF, the operating agreement did not contain a merger or no-oral-modification clause at all, and the defendant pointed to the lack of those clauses as evidence that the operating agreement was a mere piece of a series of deals constituting the Heter Iska.  Notwithstanding the conspicuous absence of a merger clause, however, the Court refused to consider evidence of those related agreements.  So, in both cases, the Court assigned no weight to the presence (or, in YMSF, the conspicuous absence) of these boilerplate clauses.  Two cases hardly make a trend, but counsel staking their client’s position on the boilerplate in an LLC’s operating agreement would be wise to carefully consider YMSF and Atlantis.

The Operating Agreement Controls, Unless Public Policy Says Otherwise