Albany—Derivative suits may be brought by members of limited liability corporations on behalf of their LLCs, even though state law provides no explicit authorization for such actions, a divided Court of Appeals ruled yesterday.

The four judges in the majority held that English and American precedents dating back to the 18th century demand that LLC members receive the same legal recourse as is available to the corporate shareholders.

“To hold that there is no remedy when corporate fiduciaries use corporate assets to enrich themselves was unacceptable in 1742 and in 1832, and it is still unacceptable today,” Judge Robert S. Smith wrote for the majority in Tzolis v. Wolf, 5.  “Derivative suits are not the only possible remedy, but they are the one that has been recognized for most of two centuries, and to abolish them in the LLC context would be a radical step.”

But the three dissenters held that “radical” is the word to describe what the majority was doing by recognizing standing for derivative suits when the Legislature intentionally deleted mention of such suits from the 1994 statute that became the Limited Liability Company Law.  What was to be Article IX in that statute authorizing derivative suits was omitted, and the law as since had a gap between its Articles VIII and X, the dissenters noted.

“The majority has effectively rewritten the law to add a right that the Legislature deliberately chose to omit,” Judge Susan Phillips Read wrote for the dissenters.  “For a Court that prides itself on resisting any temptation to usurp legislative prerogative, the outcome of this appeal is curious.”

Judge Read also called the majority’s ruling “unique in the annals of the Court of Appeals.”

“Never before has a majority of the Court read into a statute provisions or policy changes that the enacting Legislature unquestionably considered and rejected,” Judge Read wrote.

The limited liability corporation first appeared in Wyoming in 1977 and gained popularity because it offered members tax advantages and protection from personal liability.  Then in the midst of a recession, New York began discussing legislation to legalize LLCs in 1992.  In 1994, the Legislature and then Governor Mario Cuomo agreed to what became the state’s Limited Liability Company Law as a step, they said, to encourage economic development.

Limited liability corporations can be formed by filing articles of organization and paying a $200 fee to the state’s Department of State.  There are now about 372,800 active LLCs in New York State, a spokesman for the Department of State said yesterday.

The standing of members to file derivative LLC suits has been a divisive one in New York courts even before yesterday’s ruling.

The Court affirmed the Appellate Division, First Department’s unanimous finding in Tzolis v. Wolff, 39 AD3d 138 (2007), that derivative suits on behalf of LLCs are permitted (NYLJ, Feb. 9, 2007).  That First Department decision, however, had overruled Manhattan Supreme Court Justice Herman Cahn’s ruling that such claims are prohibited.

And the First Department’s finding in Tzolis was counter to the Second Department’s ruling in Hoffman v. Unterberg, 9 AD3d 386 (2004), which also held the claims to be illegal.

The majority of the Court yesterday cited other rulings, including In re Maciano v. Champion Motor Group, Inc., 2007 WL4473348,*4(Sup Ct NY County 2007), in which courts recognized direct claims by LLC members for actions that injured LLCs.  Those rulings blurred the traditional line between direct and derivative claims in apparent attempts to give LLC minority members recourse to sue over harm done to their LLCs, the majority noted.

Derivative suits often are brought against officers or directors of a corporation for violations of fiduciary duties they owe to the shareholders.  Any proceeds of a successful action are awarded to the corporation.

The Legislature’s 1994 omission of reference to derivative suits in the LLC law “does not imply such suits are prohibited,” Judge Smith wrote.

“For us, the most salient feature of the legislative history is that no one, in or out of the Legislature, ever expressed a wish to eliminate, rather than limit or reform, derivative suits,” the majority held.

The majority noted that state law implies limitations on derivative suits in the case of corporations, and suggested that limitations could be applied to LLC actions as well.

Chief Judge Judith S. Kaye and Judges Carmen Beauchamp Ciparick and Eugene F. Pigott Jr. joined the majority ruling.  Judges Victoria A. Graffeo and Theodore T. Jones Jr. concurred in Judge Read’s dissent.

Yesterday’s ruling allows minority members of Pennington Property Company LLC to pursue claims that title to a 184-room single occupancy hotel in Manhattan should be restored to their LLC.

The minority members, who own a 25 percent share of the membership interests in the LLC, contend that those in control of the corporation improperly leased the structure and then settled on a sale price of $1.9 million for the building in 2005 that is far below the fair market value.

The Upper West Side building is at 316 West 95th St.

‘Open Season’

David M. Satnick, who represented the majority Pennington members, said yesterday it is now “open season” for the filing of derivative suits against LLCs.  He contended that such actions tend to be more “onerous” on LLCs than suits filed against corporations or limited partnerships because LLCs tend to be small with fewer resources available to engage in legal battles than businesses organized differently.

Mr. Satnick, of Loeb & Loeb, said he agreed with the reasoning of the dissenters.  He attributed Judge Read’s sharp language to the dissenters’ view that the majority was venturing into territory where the judiciary should not go.

“It’s a classical case of impermissible judical legislation,” Mr. Satnick said.  “It speaks to the separation of powers of the various branches of our government.  As Judge Read very cogently states, this is really an unfortunate instance where the Judiciary has sought to recognize rights that the Legislature, in its wisdom, chose not to recognize.”

Eric S. Weinstein of Feldman Weinstein & Smith argued for the plaintiffs, Soterios and Vicky Tzolis.  Mr. Weinstein disagreed with warnings from Judge Read and Mr. Satnick that derivative claims would proliferate against LLCs in light of the Court’s ruling.

Trial courts will do their job and prevent frivolous or unwarranted suits from advancing, Mr. Weinstein said in an interview.

“The New York state Constitution grants board equity powers on our Supreme Court justice system,” he said.  “Those judges are well situated to decide the equities in a particular case.”