On March 4, 2025, the U.S. Court of Appeals for the Second Circuit issued a precedential decision in Little Hearts Marks Family II L.P. v. Carter (In re 305 East 61st Street Group LLC), 130 F.4th 272 (2d Cir. 2025), delineating the boundary between claims a member of a limited liability company may assert in their own right and those that are derivative in nature and thus may be prosecuted only by the LLC. The decision offers important guidance in particular for real estate investors, LLC members, and bankruptcy practitioners generally.
Background: A Manhattan Condo Conversion Gone Wrong
The dispute centered on 305 East 61st Street Group LLC’s (the “Debtor” or the “LLC”), a New York limited liability company that purchased and planned a condominium conversion of a 65,000-square-foot warehouse in Manhattan. The LLC’s members were 61 Prime LLC (“Prime”) (50%), Little Hearts Marks Family II L.P. (“Little Hearts”) (30% and original manager), Onestone 305, LLC (10%), and an individual investor (10%). Under the LLC’s Operating Agreement, each member was allocated specific property rights. Little Hearts’ rights included exclusive rights to the basement/cellar, first, second, and 10th floors, and the roof, along with a lease for the cellar and first floor granting unrestricted subleasing rights. These rights later became central to Little Hearts’ argument that certain claims it wished to assert were personal and enforceable directly, rather than derivative of the LLC’s claims.
The Falling Out: Management Battle and Bankruptcy Filing
By 2018, the project had stalled and relations soured. Little Hearts alleged that Prime (which by then had replaced Little Hearts as manager as the result of a ruling in a State Court proceeding) and another member used their position as managers “to squeeze out Little Hearts and transfer the [b]uilding to themselves.” Id. at 277. Although Little Hearts sought to regain management in State Court, just days before a decisive hearing, Prime caused the LLC to file Chapter 11, sidelining Little Hearts and shifting the dispute to bankruptcy court.
In bankruptcy, Little Hearts filed an adversary proceeding against Prime, asserting multiple causes of action. The Bankruptcy Court dismissed the complaint for lack of standing, holding that the claims were derivative and belonged to the estate. Thereafter, a court-appointed chapter 11 trustee confirmed a plan of liquidation, pursuant to which Prime’s principal, through a different LLC, purchased the building for $50 million. The plan also established a creditor trust to which all estate-owned claims were assigned and contained a permanent injunction barring anyone other than the trustee from pursuing claims belonging to the Debtor’s estate.
The Lawsuit: Multiple Theories, One Standing Problem
After confirmation, Little Hearts sued in state court, alleging breaches of fiduciary duties, breaches of contract, and related claims. However, after the action was removed to the Bankruptcy Court, the court dismissed the case as entirely derivative and thus barred by the plan injunction.[1] On appeal, the District Court for the Southern District of New York affirmed.[2] Little Hearts then appealed again to the Second Circuit Court of Appeals.
The Second Circuit Weighs In
On appeal, the Second Circuit was required to analyze whether the claims were properly characterized as derivative or direct. Because bankruptcy law does not itself supply a rule for distinguishing direct from derivative claims, courts look to state law, which generally governs property and related rights in bankruptcy unless a federal interest requires otherwise.[3] Accordingly, because the LLC was organized under New York law, the Second Circuit determined that it needed to apply New York law. But because New York’s highest court had not developed a clear test, the Second Circuit turned to Delaware’s well-established jurisprudence for guidance. In particular, it adopted the framework formulated in Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031, 1033, 1039 (Del. 2004), where the Delaware Supreme Court framed the test as follows:
The analysis must be based solely on the following questions: (1) Who suffered the alleged harm—the corporation or the suing stockholder individually? (2) Who would receive the benefit of any recovery or other remedy? . . . . The stockholder’s claimed direct injury must be independent of any alleged injury to the corporation. The stockholder must demonstrate that the duty breached was owed to the stockholder and that he or she can prevail without showing an injury to the corporation.
In plain terms: If the harm is to the company and any recovery would go to the company, the claim is derivative; if the harm is to the individual and the recovery would go directly to that individual, the claim is direct. Applying these principles, the Second Circuit classified Little Hearts’ claims as follows:
- Fiduciary Duty Claims – Derivative
Applying the Tooley test, the court determined that the breach of fiduciary duty and aiding-and-abetting claims were derivative. The alleged mismanagement of the project—including the Chapter 11 filing and the sale of the building—inflicted harm on the LLC as a whole, rather than on Little Hearts individually. Because the duties at issue were owed to the LLC, not directly to Little Hearts—and any recovery would flow to the estate and its creditors—these claims were derivative and barred by the plan injunction.
- Contract and Implied Covenant Claims – Direct
In contrast, the breach of contract and implied covenant claims sought to enforce rights granted specifically to Little Hearts under the operating agreement—including exclusive occupancy of certain floors, development control, and unrestricted subleasing rights. The court emphasized that these were independent contractual duties owed to Little Hearts personally, separate from any obligations to the LLC. This independence was sufficient to make the claims direct, even where the same conduct also adversely affected the LLC.
Why This Case Matters
This precedential decision is the first time the Second Circuit has squarely addressed how to distinguish direct from derivative claims in the bankruptcy context. Consistent with the Supreme Court’s directive in Butner v. United States that state law generally governs property and related rights in bankruptcy unless a federal interest requires otherwise, the Court confirmed that bankruptcy judges must carefully separate claims belonging to the estate from those individual members may pursue.
In Little Hearts, that line left fiduciary duty claims with the trustee, but preserved Little Hearts’ contract-based claims. The result cements a clear rule in the Second Circuit: if the harm is to the LLC and any recovery would flow to the estate, the claim is derivative; if the claim enforces a member’s personal or contractual rights, it is direct. That distinction will determine whether a party can actively litigate a dispute, or be sidelined while a trustee or other estate representative controls the claims.
[1] In re 305 East 61st Street Group LLC (Little Hearts Marks Family II L.P. v. Carter), No. 19-11911 (SHL), Adv. Pro. No. 21-01137 (SHL), 644 B.R. 75 (Bankr. S.D.N.Y. Oct. 11, 2022).
[2] Little Hearts Marks Family II L.P. v. Carter (In re 305 E. 61st St. Grp. LLC), No. 22-cv-9630 (PAE), 2023 WL 1961040 (S.D.N.Y. Feb. 13, 2023).
[3] See Butner v. United States, 440 U.S. 48, 55 (1979).
