Derivative claims inside your LLC: when your partner sues on the company’s behalf.

A derivative claim is a lawsuit your partner files in the name of your LLC, against you, for harm done to the company itself. New York permits it. The Court of Appeals said so in Tzolis v Wolff. Any recovery belongs to the LLC, not to him, and that single fact reshapes the whole case.

What is a derivative claim in an LLC, and can your partner really bring one?

A derivative claim in a New York LLC is a claim that belongs to the company, brought by a member because the people who control the company will not bring it themselves. The Court of Appeals recognized these claims in Tzolis v Wolff, even though the Limited Liability Company Law contains no section authorizing them.

The history matters, because your partner’s complaint depends on it. When the Legislature wrote the Limited Liability Company Law, a proposed article on derivative suits was dropped before enactment. That article would have required membership at the time of the challenged transaction, particularized pleading of demand efforts, and court approval of any settlement. None of it became statute. In Tzolis, the Court held that the omission did not abolish the right, and left its limits to the courts.

So the answer is yes. That is the beginning of the analysis, not the end.

Law: Tzolis v Wolff, 10 NY3d 100 (2008).

Is the claim against you direct or derivative, and why does the label decide the case?

Direct claims belong to the member personally. Derivative claims belong to the company. New York asks two questions, borrowed from Delaware and adopted by the First Department in Yudell v Gilbert: who suffered the alleged harm, and who would receive the benefit of any recovery. If the answer to both is the LLC, the claim is derivative.

Apply that test to the usual accusations in a two-member company. Diverting company funds harms the company. An unauthorized salary depletes company accounts. Taking a business opportunity that belonged to the LLC takes it from the LLC. Those are derivative, and the Third Department held mismanagement, misuse of company property, and diversion of funds derivative in an LLC case. An accounting demanded only because the plaintiff is a member is derivative too.

Now the defense value. A member has no individual cause of action for a wrong done to the entity, even though he watches the value of his own interest fall. That has been the rule since Abrams v Donati. The exception is narrow and he must plead into it: a duty owed to him personally, and an injury that is his alone rather than a share of the company’s. Worse for him, a complaint whose allegations confuse individual and derivative rights is subject to dismissal, and so is a count with an individual claim embedded inside a derivative one.

Read the operating agreement before the complaint. The label your partner chose binds no one. Courts look at the substance of the allegations, not the caption, and will recharacterize a personal-sounding claim that pleads company harm.

Law: Yudell v Gilbert, 99 AD3d 108 (1st Dept 2012); Abrams v Donati, 66 NY2d 951 (1985); Maldonado v DiBre, 140 AD3d 1501 (3d Dept 2016).

The money in a derivative claim was never his. He is only holding the door open so the company can walk through it.

Did your partner have to make a demand on the company before suing?

Pre-suit demand is the requirement that the member first ask the people who run the company to sue, and then plead what happened. For corporations, Business Corporation Law 626(c) makes that pleading mandatory: the complaint must set forth with particularity the effort to get the board to act, or the reason none was made.

The Limited Liability Company Law has no equivalent section. That is part of the gap Tzolis left to the courts, and New York courts have required an LLC derivative plaintiff to plead demand or futility by analogy to Business Corporation Law 626(c). Expect the question to be litigated as a corporate case, with managers standing in for directors.

Futility is the escape hatch, and it is narrow. Under Marx v Akers, demand is excused when the complaint alleges with particularity one of three things.

• A majority of the decision-makers are interested in the challenged transaction.
• The decision-makers failed to inform themselves about the transaction to a degree reasonably necessary.
• The decision-makers failed to exercise business judgment in approving the transaction, which Marx explains means a transaction so egregious on its face that it could not have been the product of sound business judgment.

Particularity is the word that does the work. A sentence saying demand would have been useless is not particularity. Names, dates, the transaction, and the reason the manager could not have judged it fairly are particularity. I read the operating agreement and the demand letter before I read the narrative of what went wrong, because the agreement says who had authority and the letter says what was asked. Derivative suits are not favored, and Bansbach v Zinn says why: they ask a court to second-guess those charged with managing the business.

One honest caution. In a two-member LLC where the accused manager is the only person who could answer a demand, futility is often easy to plead. Do not build the defense on demand alone.

Law: Business Corporation Law 626(c); Marx v Akers, 88 NY2d 189 (1996); Bansbach v Zinn, 1 NY3d 1 (2003); LNYC Loft, LLC v Hudson Opportunity Fund I, LLC, 154 AD3d 109 (1st Dept 2017).

Who controls a derivative claim once it has been filed, and who gets the money?

The LLC owns the claim, even though a member is prosecuting it, because the company is the real party whose rights are at stake. The suing member is a temporary steward. If the claim succeeds, the judgment is paid to the LLC. He shares only as a member, through his percentage, after the company is made whole.

Three practical consequences follow.

First, the company needs its own voice. The lawyer who has always handled the LLC’s work cannot simply speak for you and for the company at once, because the company is the alleged victim and you are the alleged wrongdoer. Separate counsel is the usual answer.

Second, a special litigation committee may be available, but only on the right paperwork. The First Department endorsed the practice in the LLC context generally, at least where the governing documents explicitly contemplate it, and vacated the appointment of an outside attorney as sole committee member where the operating agreements neither provided for it nor showed an intent to delegate core governance functions to nonmembers. Check the agreement first. If it is silent, the tool may not exist.

Third, settlement is not a private trade. Because the claim belongs to the company, a deal that pays the suing member personally and leaves the company’s claim unresolved invites attack from another member and scrutiny from the court. Under the corporate statute courts borrow from here, a court may in its discretion award a successful derivative plaintiff reasonable expenses including attorney’s fees, and where he receives proceeds himself, must direct him to account to the corporation for the remainder. Discretionary, not a promised payday.

Law: LNYC Loft, LLC v Hudson Opportunity Fund I, LLC, 154 AD3d 109 (1st Dept 2017); Business Corporation Law 626(e).

How does a derivative claim interact with a petition to dissolve the LLC?

Judicial dissolution of a New York LLC runs on a different standard than a derivative claim. Limited Liability Company Law 702 lets the Supreme Court decree dissolution whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or the operating agreement. That is a contract question first, not a misconduct question.

The Second Department made the point in Matter of 1545 Ocean Ave., LLC. The court starts with the operating agreement and asks whether the company can still function in conformity with it. The petitioner must show that management is unable or unwilling to reasonably permit or promote the stated purpose, or that continuing is financially unfeasible. Disagreement is not dissolution. Hostility is not dissolution. The statute is permissive, so the relief stays discretionary. It defines the operating agreement as any written agreement of the members concerning the business of the company and the conduct of its affairs, complying with section 417.

So the two proceedings answer different questions. The petition asks whether the venture can continue. The derivative claim asks whether the company was robbed. A partner who files both wants an exit and a recovery at once. Each request stands on its own facts.

Law: Limited Liability Company Law 702; Matter of 1545 Ocean Ave., LLC, 72 AD3d 121 (2d Dept 2010); Limited Liability Company Law 102(u).

Does a buyout offer make the derivative claim go away?

A buyout does not erase the LLC’s claim, but it can end your partner’s ability to prosecute it. A derivative plaintiff must be a member to sue and to keep suing, and the Second Department held that a member who withdrew from the company lost standing to maintain derivative causes of action. The company keeps the claim.

The remedy side is not automatic either. The Limited Liability Company Law does not expressly authorize a buyout in a dissolution proceeding. In certain circumstances a buyout may be an appropriate equitable remedy upon dissolution, as the Second Department held in Mizrahi v Cohen. That is discretionary relief, not a right either of you can demand.

Two things follow.

The release has to be drafted for the structure of the claim. A release of his personal claims against you does not resolve the company’s claim against you. If the purchase is meant to end the litigation, the LLC has to be a party and the company’s claim has to be released by the company.

The claim also affects the price. A pending derivative claim is an asset of the LLC. If it is real, the interest he is selling is worth more, and he will say so. If it is weak, the demand and standing defects are the reason, and that is the argument you make before you negotiate.

Law: Mizrahi v Cohen, 104 AD3d 917 (2d Dept 2013), quoting Matter of Superior Vending, LLC (Tal-Plotkin), 71 AD3d 1153 (2d Dept 2010); Jacobs v Cartalemi, 156 AD3d 605 (2d Dept 2017).

A buyout settles a relationship. Only a release from the company settles the company’s claim.

What should you do in the first week after your partner sues in the LLC’s name?

Preservation and documents come first, before any strategy discussion. The operating agreement and its amendments, the records the company keeps under Limited Liability Company Law 1102, the demand letter if one exists, and the bank statements for the transactions named in the complaint decide the early motions. Gather them before responding.

• Pull the operating agreement and every amendment. Read the management, transfer, indemnification, and member-dispute clauses.
• Read the complaint count by count, mark each one direct or derivative under the Yudell test, and note every count that mixes the two.
• Find the demand letter. If there is none, read the futility allegations word by word and test each against the three Marx grounds.
• Confirm whether the plaintiff is still a member, and whether he was one when the transaction happened.
• Preserve email, texts, accounting files, and bank records for the accounts named in the complaint. Do nothing that looks like cleanup.
• Leave company money alone. Do not change signatories, take distributions, or pay your own defense out of the LLC without reading the indemnification clause first.
• Calendar your time to answer, which runs from the date and method of service, and separately calendar the return date in any notice of petition for dissolution served with it.

Then rank the defenses. Standing and demand are threshold arguments that remove counts early. The direct versus derivative scramble is a pleading defect that can remove more. The merits, meaning what the operating agreement authorized, decide the rest.

Law: Limited Liability Company Law 1102; CPLR 3012; CPLR 403.