Holders of a minority interest in a limited liability company typically have little to no influence in the management of the company. That being said, aside from their lack of managerial involvement, they are often unaware of the other more substantial risks they may face. In New York in particular, minority members of limited liability companies run the risk of being involuntarily cashed out of the company in a “freeze-out” merger or “midnight merger,” wherein a merger takes place in secrecy—proverbially overnight—without prior notice to the minority members.

Pursuant to New York’s Limited Liability Company Law (LLCL) §1002(c), an agreement of merger must be submitted to all members entitled to vote at least 20 days in advance of the proposed merger. However, while this provision may appear to provide protection for minority members, under LLCL §407, “except as otherwise provided in the company’s operating agreement, any action which requires a vote may be taken without a meeting, without prior notice, and without a vote upon the written consent of the holders of the requisite majority.” Thus, absent heightened voting requirements in the company’s operating agreement, the holders of 51 percent or more of the company’s voting power can unilaterally approve a merger or consolidation without prior notice to the minority members, thereby forcing the minority members to surrender their interest in the company in exchange for cash. Moreover, minority members who are involuntarily cashed out have limited recourse under LLCL §1005(b) and Business Corporation Law (BCL) §623, which provide that if a former member disputes the company’s calculation of the fair market value of the former member’s interest, then a special proceeding must be commenced to fix its value.

A cautionary example of the type of sudden, freeze-out merger LLCL §407 allows for is seen in Stulman v. John Dory, No. 602365/2009, 2010 WL 10078475 (Sup. Ct. N.Y. Cnty. Sept. 10, 2010). In Stulman, the plaintiff and two individual defendants formed an LLC to develop and manage a restaurant in Manhattan. Each held a 20 percent interest in the company, together with voting rights, and the remainder of the company was owned by non-voting investors. Following a dispute between the three managers, Stulman relinquished his voting rights in exchange for $25,000. Shortly thereafter, Stulman received notice that the company had been merged into a new LLC and was offered $102,299.70, purportedly representing the fair market value of his interest in the former company. Stulman rejected the offer and commenced an action alleging that the merger was ineffective and that he was not offered the fair market value of his interest in the company.

In granting the defendants’ motion for partial summary judgment, the court found that Stulman was not entitled to prior notice of the merger because the individual defendants—who were the sole voting members following Stulman’s relinquishment of his voting rights—approved the merger utilizing a written consent in accordance with LLCL §407. Because the requisite majority approved the merger, the court held that the merger was effective despite the lack of notice and a formal vote. The court also noted that Stulman was barred from challenging the merger or seeking rescission. Instead, pursuant to LLCL §1005(b) and BCL §623, Stulman’s only recourse was to initiate a special proceeding to fix the value of his interest in the company.

Perhaps most notably, the court rejected Stulman’s argument that the merger was motivated by fraud, illegality, or self-dealing and lacked a proper corporate purpose. While the court recognized that such special circumstances could undermine the validity of a merger, the court found these allegations to be unsubstantiated and noted that “[t]he removal of members qualifies as an independent corporate purpose when the ‘removal of the minority shareholders, furthers the objective of conferring some general gain upon the corporation.’” Id. at *4 (quoting Alpert v. 28 Williams St., 63 N.Y.2d 557, 573 (1984). Thus, while a corporate purpose may be required to effectuate a freeze-out merger, the bar for proving a corporate purpose is low and the removal of minority members can itself qualify as an independent corporate purpose. Moreover, in Stulman’s case, the court also found that Stulman’s removal was in the company’s best interest because he was attempting to compete with the company.

Fraud and Illegality Allow Minority Members of an LLC to Seek More Than Appraisal Rights. Despite the harsh reality facing minority members of an LLC who are unceremoniously removed from the company without prior notice in a midnight or freeze-out merger, as the court acknowledged in Stulman, there are limited circumstances in which the minority members can challenge, enjoin, and even permanently undo a freeze-out merger if it was motivated by fraud, illegality, or self-dealing.

For example, in SBE 44 Wall, LLC v. New 44 Wall St., LLC, 2013 N.Y. Slip Op. 32104(U) (Sup. Ct. N.Y. Cnty. Aug. 29, 2013), the court found sufficient evidence that a freeze-out merger was fraudulent and lacked a proper corporate purpose. There, the plaintiffs were minority members of an LLC formed to operate certain real estate in Manhattan. The majority member, holding a 78.2 percent interest in the company, unilaterally approved a merger of the LLC into a newly-formed entity utilizing a written consent in lieu of a meeting and vote, thereby freezing out the plaintiffs without prior notice. Moreover, asserting that the value of the plaintiffs’ interest in the company was “zero,” the majority member offered the plaintiffs nothing. The plaintiffs then brought a lawsuit seeking primarily equitable relief on the grounds that the merger was fraudulent and ineffective.

In denying the defendants’ motion to dismiss, the court held that, while a dissenting member’s recourse in a freeze-out merger is ordinarily limited to an appraisal proceeding, dissenting members are permitted to bring an “appropriate action” seeking equitable relief for “unlawful or fraudulent corporate action.” Id. at *3. The court found that the plaintiffs adequately pleaded fraud by alleging that the defendants made misrepresentations regarding their management of the LLC, concealed their intention to effectuate a merger designed to freeze out the plaintiffs for no consideration, and used the need to raise capital as a sham justification for the merger. Recognizing the fraudulent motivation underlying the merger, the court observed that “plaintiffs plead in sufficient detail that the merger freezing out plaintiffs from their ownership interest in 44 Wall for no compensation was part of the defendants’ scheme to steal from them.” Id. at *9.

How Minority Members of an LLC Can Protect Themselves. While SBE 44 Wall demonstrates that minority members of an LLC may be able to successfully contest a freeze-out merger—for instance, in the rare circumstances in which a merger is motivated solely by fraud, illegality, or self-dealing, as well as when it lacks an independent corporate purpose—given the apparently low bar for demonstrating a corporate purpose, it is critical for minority members of New York LLCs to properly protect themselves against freeze-out mergers.

One effective way in which minority members can protect themselves against freeze-out mergers is to negotiate an operating agreement containing proper protections for the minority members. Although by default a merger must be approved by a majority of the members, under LLCL §1002(c), if the company’s operating agreement sets forth specific voting requirements, the merger must be approved by “such voting interests of the members as shall be required by the operating agreement.” Similarly, LLCL §407 allows members of an LLC to approve a merger without a meeting, and without a vote, only if the written consent is signed by the members holding the interests that would be necessary to authorize the merger at a meeting. Thus, for minority members, it is essential for the operating agreement to include specific voting requirements in order to prevent the majority from being able to unilaterally approve any transaction by default, as it will thwart attempts at a midnight merger.

Pursuant to LLCL §417, the members of an LLC can adopt an operating agreement that contains “any provisions not inconsistent with law or its articles of organization,” giving members wide latitude to negotiate voting requirements that ensure that all members are given advance notice and an opportunity to vote on any proposed merger. For example, minority members may wish to include heightened voting requirements such as a supermajority vote, or even unanimous consent, for certain key transactions such as a merger, a change of control, or the incurrence of substantial indebtedness. Moreover, minority members would be prudent to ensure that the operating agreement cannot be amended without the unanimous consent of all members in order to prevent the majority members from later removing voting provisions that protect the minority members. Without such protections, as reaffirmed by the case law discussed supra, minority members run the risk of being cashed out without prior notice and, in the absence of fraud, have only the limited recourse of an appraisal proceeding.

Adam S. Katz is a partner and Ryan W. McNagny is an associate in Goldberg Segalla’s corporate services and commercial litigation group. They have extensive experience in corporate transactions and commercial litigation, arbitration, and mediation.