No Implied “Disinterested” Limitation in Approving Transfers of LLC Interest

No Implied “Disinterested” Limitation in Approving Transfers of LLC Interest

      Peter Mahler, in his blog New York Business Divorce, has provided an excellent review of the decision recently handed down in Huang v. Northern Star Mgmt. LLC, 2016 N.Y. Slip Op. 32194(u) (Oct. 24, 2016). HERE IS A LINK to that review. I write as well to emphasize the question of whether a vote of the members must be disinterested and the application of the rule of independent legal significance.

      Tai Huang was a member in Northern Star Management LLC, a New York LLC, holding a 13.5% interest therein. Ling Lian Huang held another 13.5% interest, while Jian Chai Qu held a 6% interest; those three comprised the “Minority Members.” The balance of the 67% interest in Northern Star (“NSM”) was held by four unnamed and otherwise undifferentiated members (the “Majority Members”).

      After the settlement of litigation between the Minority Member and the Majority Members regarding the financing of NSM property, the Majority Members effected a cash-out merger of the Minority Members. This was accomplished by (i) the Majority Member casing to be created NewCo; (ii) the Majority Members transferring to NewCo their respective interests in NSM, receiving in return interests in NewCo; (iii) NewCo approving, as the Majority Member of NSM, a merger of NewCo with and into NSM pursuant to which all other members of NSM (i.e., the Minority Members) would be cashed-out.

     The Minority Members sought to set aside the merger on the basis that NewCo was not a member of NSM because the Majority Members’ transfers of LLC interests to its violated § 9.3 of the NSM operating agreement. Section 9.3 of the NSM Operating Agreement provided that:

[a] Member may freely transfer his interest in [NSM] to another person or entity…, only with the prior majority consent of other Members either in writing or at a meeting called for such purpose. If majority Members do not approve of the transfer, the transferee shall have no right to participate in the management of the business and affairs of [NSM] or become a Operating Member.

      The Minority Members would assert that § 9.3 required the approval of a disinterested majority of the members in order to effect a transfer of interests in NSM to NewCo. The court refused to read into the operating agreement a limitation to the “disinterested” membership. Rather:

Despite the Huangs’s contentions, Section 9.3 of the NSM Operating is completely devoid of the term “disinterested,” which is the crux of the Huangs’s application. The plain language of the provision the Huangs cite to clearly permits a member to transfer their membership interest upon approval by a simple majority of members. It does not state that a majority of the disinterested members is required, as the Huangs assert (emphasis added by court).

            From there the court concluded:

NSM and NewCo clearly established that for each of the four Majority Members each obtained majority consent from the other three Majority Members for their respective transfers. In each instance, the three non-transferring Majority Members held over 33% of the NSM membership interests, which was the collective NSM membership interest of the Minority Members. Consequently, the Minority Members never held enough membership interest  in NSM to prevent or challenge the transfers.

            The first takeaway is that absent the operating agreement requiring a disinterested vote, one will not be implied. Nothing too surprising there, although it should be recognized that where “unanimous” consent is required, courts have inserted a disinterested requirement to avoid absurd results. See, e.g., Young v. Ellis, 172 Wash. App. 1014 (Wash. Ct. App. Div. 2, Dec. 4, 2012) (where managing member of LLC was named in the operating agreement, and amendment of operating agreement required unanimous consent of the members, court rejected as “absurd” suggestion that managing member could be removed only with his consent. Rather, the operating agreement’s general rule of majority consent of the members would apply to removal of managing member.).

            Perhaps of greater import, the court did not aggregate the Majority Members in assessing the transfer of the LLC interests in NSM to NewCo. Rather, each members’ assignment was approved, inter alia, by the other members within the Majority Members; it was as if there were four distinct transfers, each approved by the other of the Majority Members. Had there been aggregation, none of the Majority Members could have voted to admit NewCo as a substitute member, and only the Minority Members, they not participating in the capitalization of NewCo, could have done so. Assuming disaggregation of members who are acting in concert is the correct rule, it presents questions as to how an operating agreement should provide for disinterested votes. Consideration needs to be given to whether and when aggregate treatment will be provided for, being aware that on certain facts aggregation may have the effect of vesting control in a minority.

The default rule under the Kentucky LLC Act is that the admission of an assignee requires the approval of a “majority-in-interest” of the members. See KRS § 275.265(1).  The Act is express that the member seeking to assign a limited liability company interest may not (unless there is a contrary provision in the operating agreement) vote with respect to the admission of the assignee as a member.  Id.  It is, however, silent as to collective action by several members, and is likewise silent as to an assignee’s inability to vote with respect to admission as a member vis-à-vis an additional traunch of interests.

 

Assume there is an LLC with 8 equal (12.5%) members.  Five of those members want to transfer their interests to Laura (not already a member).  In series, each of the five could transfer their interests to Laura as follows:

 

Assignor	Laura’s Cumulative Interest Pre-Assignment	Assignment & Admission of Laura as a Member Approved By:	Laura’s Cumulative Interest Post-Assignment
Member 1	0%	Members 2, 3, 4 & 5 (57.14% of all interests other than those held by Member 1)	12.5%
Member 2	12.5%	Laura and Members 3, 4 & 5	25%
Member 3	25%	Laura and Members 4 and 5	37.5%
Member 4	37.5%	Laura and Member 5	50%
Member 5	50%	Laura	62.5%

 

Applying the rule of independent legal significance (see KRS § 275.003(5)), members 6, 7 and 8 have had no voice with respect to Laura’s admission as a member. If, however, that result is not desired, then the operating agreement will need to: (i) waive the application of the rule of independent legal significance; (ii) adopt a test for aggregation; and (iii) provide that the participants in an aggregated transaction may not vote with respect to the admission of the assignee as a member.