Joshua D. Bernstein and Nathan T. Horst ()
Recent years have seen a flurry of activity in New York real estate from Manhattan to Brooklyn, a market that is one of the nation’s most active for new construction and surging prices. The trend has lately extended to Queens because the area has experienced a large population influx and host of new developments in Astoria and Long Island City.
Due to the pace of development in these markets, real estate investors must carefully consider how to structure and protect their ventures. Though relatively young, the limited liability company has become the preferred legal structure for real estate investment, offering members asset protection, personal liability protection, choice of taxation options and flexible management.
However, investors must be mindful that a LLC’s flexible managerial structure entails certain drawbacks. LLC operating agreements typically vest managerial authority in named manager entities or individuals, giving non-managing member investors little say in the daily operations and business of the company.
But when disputes inevitably arise between members and their manager, an issue often arises about the ability to remove and replace the unwanted manager. Consequently, LLC investors should be cognizant of the protection New York law provides.
This article focuses specifically on the protections offered by §414 of the New York Limited Liability Company Law (the Act), which permits removal of LLC managers by majority vote. This analysis examines its purpose, provisions, and relevant case law and offers advice for LLC investors looking to obtain its full benefits.
While it may seem a drastic remedy, management removal—or even its threat—is a necessary one. The authority LLC managers possess is great, and, unless circumscribed by the LLC’s operating agreement, subject to little practical limitation.
Though managers owe duties of good faith, care and loyalty to non-managing members (see Act, §409; see also Pokoik v. Pokoik, 115 A.D.3d 428, 429 (1st Dep’t 2014), those duties may be largely disclaimed in an operating agreement (see Act, §417) or may take months or years to vindicate through litigation.
During such disputes, non-managing members are thus vulnerable and at a disadvantage should an issue with management arise, and the operations of an LLC could become compromised by a protracted legal battle. Section 414, however, levels the playing field by authorizing members to remove a manager who has ceased to run an LLC competently or loyally—without the costs, delays and operational consequences of a lawsuit.
Section 414 provides that “[e]xcept as provided in the operating agreement, any or all managers of a limited liability company may be removed or replaced with or without cause by a vote of a majority in interest of the members entitled to vote thereon.” Section 414 thus specifically empowers a majority of an LLC’s membership interest-holders to remove an unwanted manager.
Adopted in 1994, case law interpreting §414 is sparse. What few cases cite the provision mostly do so only in passing. See, e.g., Janklowicz v. Landa, 2014 WL 2620299 (N.Y. Sup. Ct. N.Y. Cty. June 12, 2014) (noting §414 provides a basis for removing a manager by “a vote of a majority in interest of the members” of an LLC).
Nevertheless, in the seminal case on the issue, the Appellate Division, First Department, affirmed the use of §414 to remove a manager in Ross v. Nelson, 54 A.D.3d 258 (1st Dep’t 2008). There, the appellate division determined members of an LLC properly removed a manger by majority vote. 54 A.D.3d at 259. The appellate division held that “[e]ven though the agreement” governing the LLC “lacked a specific provision for removal of a member-manager,” the members could rely on §414′s default mechanism. Id.
The First Department’s opinion is consistent with the purpose of §414 and the Act. That is, the Act provides default terms to guide the rights and obligations of LLC managers and members where there is no operating agreement, or the operating agreement does not address a topic. See Matter of 1545 Ocean Ave., 72 A.D.3d 121, 128-29 (2d Dep’t 2010).
These default terms apply unless an operating agreement contains express provisions to the contrary. See, e.g., Mangan v. Second to None, 2016 WL 7212806, *3 n. 5 (N.Y. Sup. Ct. March 21, 2016) (noting default requirements of the Act regarding dissolution of an LLC did not apply because the operating agreement “contain[ed] a provision that expressly addresses dissolution”).
Accordingly, pursuant to Ross and the Act, where an LLC operating agreement is silent on manager removal or does not contain an express provision displacing §414, members of an LLC are entitled to rely on §414′s protections to remove and replace unwanted management.
‘Friedman’ and ‘Goldstein’
Two Supreme Court opinions have interpreted Ross more restrictively, and imposed limitations on the application of §414. These cases, Friedman v. Ridge Capital, 2010 WL 5799429 (N.Y. Sup. Ct. N.Y. Cty. Jan. 28, 2010) and Goldstein v. Pikus, 2015 WL 4627747 (N.Y. Sup. Ct. N.Y. Cty. July 20, 2015), have held that for §414 to apply, the operating agreement must first expressly allow for the expulsion of the manager.
The underpinning of these cases may be found in the trial court’s opinion in Friedman, in which the court opined that an agreement must contain some language “contemplating a change or removal of managers” in order to trigger the default provision in §414. 2010 WL 5799429 at *6.
In both Friedman and Goldstein, the opinions rested on the premise that the appellate division’s decision in Ross turned on a reference to the “expulsion of a manager” in the applicable operating agreement. Friedman, 2010 WL 5799429 at *6; Goldstein, 2015 WL 4627747 at *14. However, both opinions misconstrue the appellate division’s holding, and run contrary to the Act and its purpose.
Section 414 applies “[e]xcept as provided in the operating agreement …” Act, §414. In Ross, the appellate division looked to the applicable operating agreement to determine whether it contained an express provision that superseded §414. The appellate division determined that it did not, as the reference to the expulsion of a manager “clearly and unambiguously” evidenced that the operating agreement intended to allow for a manager’s removal. Thus, the appellate division found that nothing in the agreement provided an exception to §414′s default mechanism.
Arguably, the Goldstein and Friedman opinions erred by ascribing the wrong significance to the appellate division’s exercise.
In Ross, the appellate division simply determined nothing in the operating agreement displaced §414. The trial court decisions in Goldstein and Friedman, however, seem to have determined that the appellate division’s holding requires an operating agreement affirmatively invoke §414 by some language or else its protections are not triggered.
Neither the text of §414 nor the basic tenets of statutory construction support the above interpretation.
First, the statute’s wording does not require an operating agreement to expressly provide or contemplate manager expulsion. By its plain terms, it provides that “any” manager may be removed by a majority in interest “except as provided for in the operating agreement.” Act, §414. Thus, it requires express language to supplant it, not to trigger it.
At first blush, the Friedman and Goldstein courts, therefore, appear to have created a limitation in the statute not found in the text, which would be a violation of a primary tenet of statutory construction: Courts “cannot read into the statute that which was specifically omitted by the legislature.” Commonwealth of Northern Mariana Islands v. Canadian Imperial Bank of Commerce, 21 N.Y.3d 55 (2013).
Moreover, interpreting §414 in such a manner would be contrary to the principle that the Act’s default terms govern when an operating agreement is silent. Here, where an operating agreement is silent on manager expulsion, LLC members are entitled to rely on §414′s default remedy.
However, the Goldstein/Friedman interpretation of §414 would treat an operating agreement’s silence on removal as a waiver by implication of §414′s protections, an outcome that is not only unsupported by canons of statutory interpretation, but also undesirable because it would deprive New York LLC members of one of their most potent safeguards against manager misconduct.
Yet, the decisions in Goldstein and Friedman can and should be reconciled with the plain language of the statute and the appellate division’s decision in Ross. This is because, unlike most limited liability company operating agreements, in both Goldstein and Ross, the underlying operating agreement vested managerial authority for an unlimited term without any express limitations. In doing so, the Goldstein and Feinstein courts held that by vesting unlimited authority in the manager, the operating agreements displaced the protections of §414.
By contrast, most LLC agreements expressly limit a manager’s authority as being “subject to” the Act, which necessarily invokes the limitation contained in §414.
Thus, even under the Goldstein/Friedman interpretation of the statute, §414 would apply to allow for the removal of managers in virtually all real estate LLCs. As such, §414 remains a powerful tool for non-managing LLC members, who should ensure they are not deprived of its benefits when drafting their operating agreements.