Tzolis v. Wolff

• Decision Date: 14 February 2008
• Docket Number: 5.
• Citation: Tzolis v. Wolff, 10 NY3d 100, 884 N.E.2d 1005, 855 N.Y.S.2d 6 (N.Y. 2008)
• Parties: Soterios (Steve) TZOLIS et al., Individually and in the Right and on Behalf of Pennington Property Co. and Another, et al., Respondents, v. Herbert WOLFF et al., Defendants, and Parkway LLC et al., Appellants.
• Court: New York Court of Appeals Court of Appeals

884 N.E.2d 1005

10 N.Y.3d 100

855 N.Y.S.2d 6

Soterios (Steve) TZOLIS et al., Individually and in the Right and on Behalf of Pennington Property Co. and Another, et al., Respondents, v. Herbert WOLFF et al., Defendants, and Parkway LLC et al., Appellants.

5.

Court of Appeals of New York.

February 14, 2008.

Loeb & Loeb LLP, New York City (David M. Satnick, David B. Eizenman and John A. Piskora of counsel), for appellants.

Feldman Weinstein & Smith LLP, New York City (Eric S. Weinstein and Yong Hak Kim of counsel), for respondents.

[855 N.Y.S.2d 102]

OPINION OF THE COURT

SMITH, J.

We hold that members of a limited liability company (LLC) may bring derivative suits on the LLC's behalf, even though there are no provisions governing such suits in the Limited Liability Company Law.

Facts and Procedural History

Pennington Property Co. LLC was the owner of a Manhattan apartment building. Plaintiffs, who own 25% of the membership interests in the LLC, bring this action "individually and in the

[855 N.Y.S.2d 103]

right and on behalf of the company. Plaintiffs claim that those in control of the LLC, and others acting in concert with them, arranged first to lease and then to sell the LLC's principal asset for sums below market value; that the lease was unlawfully assigned; and that company fiduciaries benefitted personally from the sale. Plaintiffs assert several causes of action, of which only the first two are in issue here: The first cause of action seeks to declare the sale void, and the second seeks termination of the lease.

Supreme Court dismissed these causes of action. It held that they could not be brought by plaintiffs individually, because they were "to redress wrongs suffered by the corporation" (12 Misc.3d 1151[A], 2006 N.Y. Slip Op 50851[U], *4, 2006 WL 1310621). It also held, following Hoffman v. Unterberg, 9 A.D.3d 386, 780 N.Y.S.2d 617 (2d Dept.2004), that "New York law does not permit members to bring derivative actions on behalf of a limited liability company" (id. at *5). The Appellate Division, concluding that derivative suits on behalf of LLCs are permitted, reversed (39 A.D.3d 138, 829 N.Y.S.2d 488 [1st Dept 2007]), and granted two defendants permission to appeal on a certified question. We now affirm the Appellate Division's order.

Discussion

The issue is whether derivative suits on behalf of LLCs are allowed. The basis for appellants' argument that they' are not is the Legislature's decision, when the Limited Liability Company Law was enacted in 1994, to omit all reference to such suits. We hold that this omission does not imply such suits are prohibited. We base our holding on the long-recognized importance of the derivative suit in corporate law, and on the absence of evidence that the Legislature decided to abolish this remedy, when it passed the Limited Liability Company Law in 1994.

I

The derivative suit has been part of the general corporate law of this state at least since 1832. It was not created by statute, but by case law. Chancellor Walworth recognized the remedy in Robinson v. Smith, 3 Paige Ch. 222 (1832), because he thought it essential for shareholders to have recourse when those in control of a corporation betrayed their duty. Chancellor Walworth applied to a joint stock corporation — then a fairly new kind of entity — a familiar principle of the law of trusts: that a beneficiary (or "cestui que trust") could bring suit on behalf of a trust when a faithless trustee refused to do so. Ruling that

[855 N.Y.S.2d 104]

shareholders could sue on behalf of a corporation under similar circumstances, the Chancellor explained:

"The directors are the trustees or managing partners, and the stockholders are the cestui que trusts, and have a joint interest in all the property and effects of the corporation.... And no injury the stockholders may sustain by a fraudulent breach of trust, can, upon the general principles of equity, be suffered to pass without a remedy. In the language of Lord Hardwicke, in a similar case [Charitable Corp. v. Sutton, 2 Atk. 400, 406 (Ch. 1742)], `I will never determine that a court of equity cannot lay hold of every such breach of trust. I will never determine that frauds of this kind are out of the reach of courts of law or equity; for an intolerable grievance would follow from such a determination.' (3 Paige Ch. at 232.)

Eventually, the rule that derivative suits could be brought on behalf of ordinary business corporations was codified by statute (see Business Corporation Law § 626[a]). But until relatively recently, no similar statutory provision was made for another kind of entity, the limited partnership; again, the absence of a statute did not prevent courts from recognizing the remedy. In Klebanow v. New York Produce Exck, 344 F.2d 294 (2d Cir.1965, Friendly, J.), the Second Circuit Court of Appeals held that limited partners could sue on a partnership's behalf. For the Second Circuit, the absence of a statutory provision was not decisive because the court found no "clear mandate against limited partners' capacity to bring an action like this" (id. at 298 [emphasis added]). We agreed with the holding of Klebanow in Riviera Congress Assoc. v. Yassky, 18 N.Y.2d 540, 547, 277 N.Y.S.2d 386, 223 N.E.2d 876 (1966, Fuld, J.), relying, as had Chancellor Walworth long before, on an analogy with the law of trusts:

"There can be no question that a managing or general partner of a limited partnership is bound in a fiduciary relationship with the limited partners ... and the latter are, therefore, cestuis que trustent .... It is fundamental to the law of trusts that cestuis have the right, `upon the general principles of equity' (Robinson v. Smith, 3 Paige Ch. 222, 232) and `independently of [statutory] provisions' (Brinckerhoff v. Bostwick, 88 N.Y. 52, 59), to sue for the benefit of the trust on a cause of action which

[855 N.Y.S.2d 105]

belongs to the trust if `the trustees refuse to perform their duty in that respect'. (Western R.R. Co. v. Nolan, 48 N.Y. 513, 518....)"

After Klebanow and Riviera were decided, the Partnership Law was amended to provide for derivative actions by limited partners (see Partnership Law § 115-a [1]).

We now consider whether to recognize derivative actions on behalf of a third kind of entity, the LLC, as to which no statutory provision for such an action exists. In addressing the question, we continue to heed the realization that influenced Chancellor Walworth in 1832, and Lord Hardwicke 90 years earlier: When fiduciaries are faithless to their trust, the victims must not be left wholly without a remedy. As Lord Hardwicke put it, to "determine that frauds of this kind are out of the reach of courts of law or equity" would lead to "an intolerable grievance" (Charitable Corp. v. Sutton, 2 Atk. at 406).

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. 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.

Some of the problems such an abolition would create may be seen in the development of New York law since the Limited Liability Company Law, omitting all reference to derivative suits, was passed in 1994. Several courts have held that there is no derivative remedy for LLC members (see Hoffman v. Unterberg, 9 A.D.3d 386, 780 N.Y.S.2d 617 [2d Dept.2004]; Lio v. Mingyi Zhong, 10 Misc.3d 1068[A], 2006 N.Y. Slip Op. 50016[U], 2006 WL 37044 [Sup.Ct., N.Y. County 2006]; Schindler v. Niche Media Holdings, 1 Misc.3d 713, 716, 772 N.Y.S.2d 781 [Sup.Ct., N.Y. County 2003]). But since the Legislature obviously did not intend to give corporate fiduciaries a license to steal, a substitute remedy must be devised. Perhaps responding to this need, some courts have held that members of an LLC have their own, direct claims against fiduciaries for conduct that injured the LLC — blurring, if not erasing, the traditional line between direct and derivative claims (see Matter of Marciano [Champion Motor Group, Inc.], 2007 N.Y. Slip Op. 84071[U], *4, 2007 WL 4473342 [Sup.Ct., Nassau County 2007]; Out of the Box Promotions LLC v. Koschitzki, 15 Misc.3d 1134[A], 2007 N.Y. Slip Op 50973[U], *7, 2007 WL 1374501 [Sup.Ct., Kings County 2007]; Lio, 2006 N.Y. Slip Op 50016[U], at *4). Similarly, Supreme Court's decision in this case upheld several of plaintiffs' claims that are not in issue here, characterizing

[855 N.Y.S.2d 106]

the claims as direct, though they might well be derivative under traditional analysis (see generally, Kleinberger, Direct Versus Derivative and The Law of Limited Liability Companies, 58 Baylor L. Rev. 63 [2006]).

Substituting direct remedies of LLC members for the old-fashioned derivative suit — a substitution not suggested by anything in the language of the Limited Liability Company Law — raises unanswered questions. Suppose, for example, a corporate fiduciary steals a hundred dollars from the treasury of an LLC. Unquestionably he or she is liable to the LLC for a hundred dollars, a liability which could be enforced in a suit by the LLC itself. Is the same fiduciary also liable to each injured LLC member in a direct suit for the member's share of the same money? What, if anything, is to be done to prevent double liability? No doubt, if the Legislature had indeed abolished the derivative suit as far as LLCs are concerned, we could and would answer these questions and others like them. But we will not readily conclude that the Legislature intended to set us on this uncharted path.

II

As shown above, courts have repeatedly recognized derivative suits in the absence of express statutory authorization (Robinson v. Smith, 3 Paige Ch. 222 [1832]; Klebanow v. New York Produce Exch., 344 F.2d 294 [2d Cir.1965]; Riviera Congress Assoc. v. Yassky, 18 N.Y.2d 540, 277 N.Y.S.2d 386, ...