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Pappas Saga Ends, Court of Appeals Upholds Fiduciary Waiver in LLC Buy-Out Agreement

Posted in Buyout, LLCs

The roller-coaster ride known as Pappas v. Tzolis came to an end last week when New York’s highest court threw out a lawsuit by two disappointed sellers of LLC membership interests who accused the third, purchasing member of not disclosing at the time of sale that he already had lined up a buyer for the LLC’s sole asset at a huge premium. Pappas v. Tzolis, 2012 NY Slip Op 08053 (Ct App Nov. 27, 2012).

The Court of Appeals’ decision, enforcing a fiduciary waiver provision in the membership transfer agreement, follows in the wake of the same court’s rulings last year in the Centro and Arfa cases, likewise rejecting fiduciary breach claims between business co-owners in the face of releases given in connection with the challenged transactions. (Read here my post on the Centro and Arfa cases.) The Centro-Arfa-Pappas trilogy sends a clear message that, at least where the co-owners’ relationship is no longer one of unquestioning trust, a fiduciary’s assertions surrounding the challenged transaction cannot be blindly relied upon to overcome a contractual release or waiver of fiduciary duty.

This is my fourth post on the various stages of the Pappas case, starting with the trial court’s March 2010 decision dismissing the lawsuit based on a clause in the LLC’s operating agreement permitting the members to engage in other competitive activities (read here); the Appellate Division, First Department’s decision in September 2011 reinstating the complaint on the grounds that neither the competition clause nor an express fiduciary waiver in the membership transfer agreement voided the purchasing member’s duty to disclose his impending deal to sell the LLC’s realty asset (read here); and the videotaped oral argument of the appeal last October before the Court of Appeals (read here).

As predicted in my last post on the oral argument, the Court’s decision last week pivots on the Court’s conclusion that the Pappas complaint’s allegations, reflecting an “antagonistic” relationship between the members in the year leading up to the buy-out, as in Centro imposed on the selling members a “heightened degree of diligence” in which “the principal is aware of information about the fiduciary that would make reliance on the fiduciary unreasonable.” In other words, as Judge Pigott wrote in his opinion for the Court,

plaintiffs’ own allegations make it clear that at the time of the buyout, the relationship between the parties was not one of trust, and reliance on Tzolis’s representations as a fiduciary would not have been reasonable. According to plaintiffs, there had been numerous business disputes, between Tzolis and them, concerning the sublease. The relationship between plaintiffs and Tzolis had become antagonistic, to the extent that plaintiffs could no longer reasonably regard Tzolis as trustworthy. Therefore, crediting plaintiffs’ allegations, the release [fiduciary waiver] contained in the Certificate is valid, and plaintiffs cannot prevail on their cause of action alleging breach of fiduciary duty.

The Court’s decision also highlights two other factors that, to one or another degree, may have influenced the outcome:

  • The plaintiffs were “sophisticated businessmen represented by counsel” in connection with the buy-out transaction.
  • Tzolis offered to buy plaintiffs’ membership interests for 20 times what they paid for them one year earlier, making “obvious” plaintiffs’ “need to use care to reach an independent assessment of the value of the lease.”

When relations between business partners become rancorous, a voluntary buy-out can be a sensible and efficient way to maximize value for all. The Centro-Arfa-Pappas trilogy instructs that this very same rancor can defeat a subsequent claim by the seller that the purchaser made misrepresentations or withheld material information affecting value that he or she was duty-bound to disclose. The trilogy also suggests that the First Department’s decisions in the Blue Chip Emerald and Littman cases, upholding fiduciary breach claims notwithstanding releases given as part of buy-outs, and which were directly criticized by the Court of Appeals in Centro, are, at best, circumscribed to cases where the trust relationship between buying and selling co-owners remains pristine.

For transactional lawyers, Pappas reconfirms the importance on the purchaser side of including release, disclaimer and waiver language in the buy-out agreement that expressly acknowledges the purchaser’s non-fiduciary status in regard to the transaction, the seller’s non-reliance on any representations of value or non-disclosures by the purchaser, the satisfactory completion of the seller’s own due diligence, and the seller’s acceptance of risk that the subject company may have a value higher than that used as the basis for the buy-out.

For litigation counsel, Pappas likely will lead to the filing of complaints on behalf of disgruntled sellers that omit any mention of disputes between the co-owners leading up to the challenged buy-out. This technique would, at a minimum, increase the odds of avoiding dismissal at the pre-answer stage of the case and allow pre-trial discovery.