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Posted: March 22, 2018

Estate of Deceased LLC Member Lacked Standing to Bring Derivative Claims

On February 22, 2018, Justice Scarpulla of the New York County Commercial Division issued a decision in Pappas v. 38-40 LLC, 2018 NY Slip Op. 30329(U), holding that the estate of a deceased member of an LLC lacked standing to bring a derivative action, explaining:

Moving Defendants argue that Plaintiff does not have standing to pursue the derivative causes of action pled in the complaint because Plaintiff is not a member of 38-40 LLC. To pursue a claim derivatively on behalf of a limited liability company, a plaintiff must be a member of the limited liability company at the time of the alleged wrong, at the commencement of the lawsuit, and throughout litigation.

Under the terms of the terms of the Operating Agreement, a Member’s death constitutes a “Withdrawal Event,” which terminates the continued membership of the deceased Member in 38-40 LLC. The Operating Agreement further provides that any successor in interest to such Member (including any executor, administrator, heir) is not entitled to any rights or interest of such Member in 38-40 LLC, other than the allocations and distributions to which such Member is entitled, unless such successor in interest is admitted as a Member in accordance with this Agreement.

To be admitted as a new Member of 38-40 LLC, two events must occur. First, the person seeking membership must obtain the consent of Members holding at least Fifty One (51%) percent of the Percentage Interests. Next, as a condition to the admission of a new Member, such Member shall execute and acknowledge such instruments, in the. form and substance satisfactory to the LLC, as the LLC may deem necessary or desirable to effectuate such admission and to confirm the agreement of such Member to be bound by all of the terms, covenants and conditions of this Agreement, as the same may have been amended.

As expressly provided in Operating Agreement § 16, Pappas’s membership in the LLC terminated upon his death on· October 31, 2015. The Operating Agreement also expressly provides that Plaintiff, as Personal Representative of the Pappas Estate, is a successor in interest only, and is entitled to Pappas’s allocations and distributions but not his membership rights or interests. Under the plain terms of the Operating Agreement neither Plaintiff nor the Pappas Estate are Members of 38-40 LLC, thus Plaintiff lacks standing to pursue derivative claims on 38-40 LLC’s behalf.

In opposition, Plaintiff does not allege that she ever sought admission as a new Member and received consent from 51 % of the existing Members, as required by the Operating Agreement § 15. Instead, Plaintiff submits a Form 1065 (Schedule K-1) of the LLC’s 2015 federal tax return and argues that the Pappas Estate is a Member of the LLC because, under Item G of the form; the limited partner or other LLC Member box is checked.

Tax form 1065 (Schedule K-1) is a document used to report an individual’s income from a limited liability company, and is insufficient to show that either Plaintiff or the Pappas Estate is or ever became a member of 38-40 LLC. Accordingly, that part of the cross-motions to dismiss the derivative claims for lack of standing is granted, and Plaintiffs causes of action one through nine are dismissed with prejudice.

(Internal citations and quotations omitted) (emphasis added).

This decision touches on two areas of commercial litigation that are a significant part of our practice: derivative actions (where a shareholder brings an action on behalf of a corporation) and business divorce (a break-up between the owners of a closely-held business). Contact Schlam Stone & Dolan partner John Lundin at jlundin@schlamstone.com if you or a client have questions regarding either of these issues.

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