Recent Appellate Rulings Clarify Standards for Challenging Releases Given to Fiduciaries of Closely Held Business Entities: Part 2
This is the second of two posts analyzing two recent decisions by the Manhattan-based Appellate Division, First Department, in which the court dismissed fraudulent inducement claims by LLC members against co-member fiduciaries arising from agreements that included broad general releases. Last week's post examined Centro Empresarial Cempresa S.A. v. America Movil S.A.B. de C.V., 2010 NY Slip Op 04719 (1st Dept June 3, 2010), which involved a dispute over a buyout between members of a Delaware LLC that owned an Ecuadorian mobile telephone company. The second case, discussed in this week's post, also concerns a dispute between co-members of a Delaware LLC, but this time the business operations are closer to home, involving a series of real estate acquisitions in New York City.
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The case of Arfa v. Zamir is one of those hydra-headed business partnership disputes that takes on a life of its own, generating multiple lawsuits and dozens of motions, decisions and appeals that take up years before anything seems to get resolved on the merits. I've written up decisions in the Arfa family of cases on several prior occasions, most recently on the issue whether LLC promoters are fiduciaries (see here), before that on indemnification rights of LLC managers (see here), and before that on whether a general release of a LLC fiduciary given as part of an inter-member transaction bars a subsequent action for fraudulent inducement (see here).
The last-mentioned post highlighted a December 2008 decision by Manhattan Commercial Division Justice Charles E. Ramos refusing to dismiss a fraudulent inducement claim by plaintiffs Rachel Arfa and her husband, Alexander Shpigel, as 60% members of the subject LLC, against defendant Gadi Zamir, who held the remaining 40% interest, relating to a real estate acquisition and development venture in upper Manhattan known as Academy Street. Here's a short summary of the factual background from my prior post:
The plaintiffs allege that in late 2004, Zamir recommended that the parties acquire Academy Street based on various income and expense projections, and that in reliance on Zamir's recommendation and presentations they approved the deal which closed in April 2005. Plaintiffs allege that in the summer of 2005, they learned of serious problems with the building's physical condition which allegedly were known to Zamir and withheld from plaintiffs at the time Zamir solicited their approval.
Meanwhile, plaintiffs and Zamir entered into a Governance Agreement dated June 9, 2005, which was intended to resolve growing frictions between them over management and control of the entire real estate portfolio. The plaintiffs allege that they "reluctantly agreed" to Zamir's "demand" that they enter into the Governance Agreement "to appease Zamir and prevent him from destroying the value of the real estate portfolio . . .." Mutual veto power over management decisions appears to be the main thrust of the Governance Agreement. The Governance Agreement also contains a mutual general release in which the parties release one another from "any and all claims . . . known or unknown" arising from events that pre-date the Governance Agreement.
Zamir moved to dismiss the plaintiffs' Fifth Cause of Action for fraudulent inducement, arguing that it was barred by the release contained in the Governance Agreement. Justice Ramos's December 2008 decision denied the motion, holding that under the First Department's decision in Littman v. Magee, 54 AD3d 14 (1st Dept 2008),
to the extent that Zamir owed Plaintiffs a fiduciary duty by virtue of being co-managers, he may not rely upon the Release to insulate himself from liability where he intentionally concealed from Plaintiffs the physical condition of the Academy Street Property, and which misrepresentation was an inducement to enter into the release from the outset.
Zamir appealed. On July 13, 2010, the First Department handed down its decision, reported at 2010 NY Slip Op 06070, reversing Justice Ramos's ruling and dismissing the fraudulent inducement claim. The court's unanimous decision was authored by Associate Justice David Friedman who also wrote the majority opinion in the First Department's 3-2 ruling in the Centro case discussed in last week's post.
Justice Friedman's Arfa opinion emphasizes factors closely tracking those found critical in Centro. He notes that the fraudulent inducement claim:
- "falls squarely within the scope of the general release";
- that the Governance Agreement "was the result of rigorous, arm's-length negotiations between the highly sophisticated parties";
- that "by the time the parties began negotiating the Governance Agreement, they had already developed an adversarial, even hostile relationship";
- that given the plaintiffs' own allegations of Zamir's dishonesty, they had a "heightened" affirmative duty to protect themselves from misrepresentations by investigating all of the circumstances and details surrounding the Governance Agreement;
- that had the plaintiffs performed the requisite due diligence, the matters concerning the Academy Street Building's physical condition, about which Zamir allegedly made misrepresentations, "presumably would have been revealed"; and
- that the plaintiffs could not establish reasonable reliance on Zamir's alleged misrepresentations when they failed to make "any use of the means available to them to ascertain the truth of the alleged misrepresentations at issue before they entered into the Governance Agreement."
Justice Friedman, quoting from his Centro opinion, also rejects what he calls the "implication" of the plaintiffs' position, i.e., that "a fiduciary can never obtain a valid release without first making a full confession of its sins to the releasor," and then goes on to distinguish Littman v. Magee, writing:
In Littman, a general release in the agreement for the sale of the plaintiff's interest in a closely-held business was held not to bar a fraud action against a former fiduciary at the pleading stage because the complaint was deemed to allege that the defendant fiduciary had told the plaintiff that no further documentation bearing on the valuation of the enterprise existed. While Littman reaffirmed that even a fraud claim against a fiduciary must establish justifiable reliance on the alleged misstatement, the case held that the alleged misrepresentation concerning the availability of information relevant to the transaction raised an issue as to whether plaintiff justifiably relied on the defendant's statements without making further investigative efforts (54 AD3d at 19). Here, by contrast, Arfa/Shpigel do not allege that Zamir did or said anything to impede their ability to investigate the truth and completeness of his representations concerning the Academy Street building. On the contrary, assuming the truth of the complaint, Arfa/Shpigel never asked Zamir for even a page of documentation of the condition of the building.
So there you have it. Two First Department decisions, Centro and Arfa, both of which limit Littman to its specific facts and implicitly reject Littman's broader pronouncements suggesting that a release given to a fiduciary does not protect against a nondisclosure-based, fraudulent inducement claim. As noted last week, the Centro plaintiffs filed a notice of appeal as of right to the Court of Appeals, which will have the last word, so stay tuned.
Recent Appellate Rulings Clarify Standards for Challenging Releases Given to Fiduciaries of Closely Held Business Entities: Part 1
Two years ago, in Littman v. Magee, 54 AD3d 14 (1st Dept 2008), the Manhattan-based Appellate Division, First Department, made waves with a decision in which it reinstated a complaint for breach of fiduciary duty and fraudulent inducement by an LLC member who sold his minority interest to the majority, gave them a comprehensive release and, over a year later, after the majority sold the company at a substantial premium, claimed he had been misled as to the true value of his interest. My write-up of the decision (read here) referred to Littman as "lowering the bar" for claims of this sort by making broad pronouncements that seemingly elevated beyond the power of release the purchaser-fiduciary's duty to disclose to the seller all material facts bearing on the transaction. At the time, with some degree of concern, I posed the question, "After Littman, can business owners pursue and exploit the profitable sale of their business or its assets without risk of liability to a former partner whose interest was acquired at a cheaper price?"
In a recent pair of decisions, the First Department effectively has enervated Littman's broad pronouncements regarding the inefficacy of releases vis-à-vis the fiduciary duty of disclosure. In Centro Empresarial Cempresa S.A. v. America Movil S.A.B. de C.V., 2010 NY Slip Op 04719 (1st Dept June 3, 2010) (hereafter "Centro"), and Arfa v. Zamir, 2010 NY Slip Op 06070 (1st Dept July 13, 2010) (hereafter "Arfa"), lower courts had denied motions to dismiss fraudulent inducement claims by LLC members who entered into transactions which included an exchange of general releases. In both cases, the plaintiffs argued, and the lower courts agreed, that under Littman a general release does not insulate a fiduciary from liability for failing to disclose the fiduciary's own wrongdoing. On appeal in both cases, the First Department reversed the lower courts' orders and directed dismissal of the claims, finding that the plaintiffs had failed to allege facts sufficient to set aside their releases. In both cases, the First Department expressly distinguished Littman by limiting it to its particular facts.
Interestingly, both appellate decisions were authored by Associate Justice David Friedman who was not on the panel that decided Littman as were none of the other Arfa panel members and only one of the Centro panel members. As related below, the one Centro panel member who also decided Littman -- Associate Justice Catterson -- was half of a two-judge dissent in Centro.
In this Part One of a two-part series, I report on the Centro decision. In next week's Part Two, I'll report on the Arfa decision.
The Centro Decision
Centro involved a dispute between minority and majority members of a Delaware LLC that owned an Ecuadorian mobile telephone company known as Conecel. In March 2000, the majority member Telmex (controlled by Mexican billionaire Carlos Slim) acquired a 60% interest in Conecel. Telmex simultaneously entered into two agreements with the plaintiff minority members. The first stipulated that, in the event Telmex rolled up its Latin American telecommunications interests into one entity for the purpose of an equity offering, the plaintiffs would have the right to exchange their interest in Conecel for an interest in the new entity (the "Roll-Up Agreement"). The second agreement gave plaintiffs the right to put their Conecel interests to Telmex at specified intervals spread over 6 1/2 years at a fixed price based on Conecel's 1999 valuation (the "Put Agreement").
The plaintiffs alleged that Telmex's formation in late 2000 of a new company known as America Movil triggered their right of exchange under the Roll-Up Agreement. They further alleged that over the next year Telmex dodged most of their requests for financial information necessary to determine the exchange rate, and that the information they did extract painted a false, bleak picture of the company's finances.
Having been led to believe that Conecel was in financial difficulty, in March 2002 the plaintiffs exercised their first put right under the Put Agreement by selling 50% of their membership interests to Telmex for $64 million. After another year of alleged obfuscation and misrepresentation by Telmex of Conecel's financial condition, in March 2003 Telmex offered to purchase the plaintiffs' remaining 50% interest ahead of the Put Agreement's schedule at the same floor price of $64 million. In July 2003, Telmex and the plaintiffs entered into a Purchase Agreement for the remaining 50% which also included a broad general release in Telmex's favor of all claims relating to the plaintiffs' membership interests in Conecel.
Plaintiffs' complaint alleged that, years after the buy-out of their interest, Telmex's alleged dishonesty was exposed as a result of an audit of Conecel by the Ecuadorian tax authority which allegedly revealed that Conecel's true financial results in 2001-03 were considerably better than represented by Telmex when it offered to purchase plaintiffs' interests. Plaintiffs claimed that, had Telmex honored their right to negotiate an exchange of their Conecel units for America Movil shares, plaintiffs would have owned America Movil shares worth more than $1 billion as of May 30, 2008 (the date of the complaint).
The lower court, in an unreported December 2008 decision dictated on the record by Justice Richard B. Lowe III, denied Telmex's dismissal motion in which Telmex contended that the general release given by plaintiffs barred their claim. Telmex appealed.
Over a vigorous two-judge dissent, a three-judge majority reversed the lower court's order and dismissed the complaint. The self-responsibility theme of Justice Friedman's majority opinion is struck early, in his description of the facts, when he notes that
It is undisputed that the Purchase Agreement [including the general release] was the product of rigorous, arm's length negotiations between sophisticated parties, all of whom were advised by their own expert legal counsel.
The legal analysis portion of Justice Friedman's opinion initially establishes that the plaintiffs' fraudulent inducement claim falls squarely within the scope of the broad release given in the Purchase Agreement, and that "[w]hether or not plaintiffs had reason to suspect that defendants were misrepresenting the value of Conecel in the negotiation of the 2003 transaction, they cannot reasonably contend that they did not intend to release possible fraud claims as to that matter of which they were unaware."
Justice Friedman then strongly rejects the central premise of plaintiffs' Littman argument, keyed to Telmex's fiduciary status as the controlling member of Conecel, writing as follows:
While Telmex LLC, as the holder of the majority interest in TWE (and, through TWE, Conecel) owed plaintiffs certain fiduciary duties, the foregoing principles apply (at least among sophisticated parties advised by counsel) even where the releasee is a fiduciary. If Telmex LLC's fiduciary status alone sufficed to prevent it from obtaining the dismissal of this action based on the 2003 release, the implication would be that a fiduciary can never obtain a valid release without first making a full confession of its sins to the releasor, regardless of the releasor's sophistication and the arm's length nature of the negotiations from which the release emerged. This is not the law. Such a rule would render useless and meaningless any release of a party that owed the releasor a fiduciary duty, thereby unjustifiably impinging on the freedom of commercial actors to order their own affairs by contract and, moreover, contravening the public policy favoring the settlement of business disputes. We are not aware of any precedent compelling us to accept such an absurd result. [Citations omitted.]
The plaintiffs, Justice Friedman continues, "entered into the 2003 transaction well aware that defendants had not given them access to the internal financial records of Conecel" and "should have insisted on access to Conecel's internal books and records" and, moreover, should have sued if necessary to obtain the information. He also notes that during the period in question, "relations between the parties were adversarial, if not outright hostile, thereby negating as a matter of law any inference that business entities as sophisticated as plaintiffs were relying on defendants for an objective assessment of the value of their investment."
Justice Friedman distinguishes Littman in a footnote. He does not confront Littman's broad pronouncements, but instead focuses on the specific factual allegations in that case, writing as follows:
[In Littman], a general release in the agreement for the sale of the plaintiff's interest in a closely-held business was held not to bar a fraud action against a former fiduciary at the pleading stage because the complaint was deemed to allege that the defendant fiduciary had told the plaintiff that no further documentation bearing on the valuation of the enterprise existed, thereby exonerating the plaintiff from the need to investigate further (54 AD3d at 19). Here, plaintiffs do not allege that defendants told them that no information about Conecel's financial condition beyond the minimal amount that had been shared with plaintiffs was in existence. In addition, the Littman plaintiff alleged that he was induced to sell out in part by a "threat[] that if [he] did not agree to the proposed sale, approximately $1 million in income would be allocated to him for the year 2004, while no distribution would be made to him to cover the taxes resulting from that allocation" (id. at 16). No such threat or duress is alleged here.
Justice Friedman's opinion also distinguishes Littman's doctrinal forebear, Blue Chip Emerald v. Allied Partners, 299 AD2d 278 (1st Dept 2002), where the First Department upheld a fraudulent inducement claim involving a buy-out of a minority partner who alleged that the majority kept secret a third-party offer for the company's sole asset at a substantially higher price. Here's what he says about Blue Chip:
It was critical to the result in Blue Chip that the plaintiff in that case did not have "at its disposal ready and efficient means" for ascertaining whether such an oral agreement (or an offer in the relevant price range) even existed (299 AD2d at 280). Here, by contrast, plaintiffs were well aware that Conecel did have a value, and nonetheless chose to cash out their interests without either insisting on verifying defendants' representations as to that value or, on the other hand, conditioning the deal on the accuracy of the information they did receive. Indeed, as previously discussed, plaintiffs here were well aware that they were not in possession of all the information they believed they were entitled to when they sold their interests.
In a lengthy dissent, Associate Justice James M. Catterson sharply takes the majority to task for "overlook[ing] the well-established precept that releases 'must be knowingly and voluntarily entered into', and propound[ing], instead, the view that an effective release is one in which the releasor is hoodwinked by the releasee" (citations omitted). Citing Littman, Justice Catterson writes that a general release "will not insulate a tortfeasor from allegations of breach of fiduciary duty, where it has not fully disclosed alleged wrongdoing," and therefore the plaintiffs in Centro
were reasonably justified in their expectations that the defendants would disclose any information in their possession that might affect plaintiffs' decision on their best course of action especially as to signing the release that the defendants now argue bars this action.
Justice Catterson also disagrees with what he calls "the majority's attempt to distinguish Littman," writing that
The majority does so on the basis that the plaintiff in Littman was told that no further documentation bearing on the valuation of the enterprise existed, thus exonerating him from the need to investigate further whereas here the plaintiffs were not so told. I fail to see how being told that no documentation exists provides a better basis for exoneration than receipt of publicly filed documents. In the instant case, whatever message was being conveyed by the defendants' stonewalling, it was not incumbent on the plaintiffs to suspect that the defendants were defrauding a governmental agency by publicly filing false information.
On June 21, 2010, the plaintiffs in Centro filed a notice of appeal to the New York Court of Appeals which they are allowed to do as of right because of the two-judge dissent. It will be most interesting and important to see how the state's highest tribunal resolves the clash of judicial philosophies evident in the dueling opinions of the Centro majority and dissenters.
Are LLC Organizers Fiduciaries?
Will there be a new wave of lawsuits by disappointed investors in business enterprises organized as limited liability companies, alleging that the investors were solicited to become members by slick, fast-talking promoters who concealed their own self-dealing in violation of a fiduciary duty of disclosure that existed even before the LLC was formed? A recent New York appellate ruling has opened the door to just such suits.
By the beginning of the 18th century, when Daniel Defoe wrote about the "Villainy of Stock-Jobbers", the public held a contemptuous view of those who traded in the proto stock markets of the time. In the late 19th century, the term "promoter", referring to those who organized companies and sold shares, likewise took on derogatory shades amidst an industrial boom that experienced no shortage of flim-flam artists exploiting an unprecedented wave of public investment in railroads, utilities, heavy industry and real estate development companies.
Common-law courts in the U.S. reacted by imposing fiduciary duties on corporate promoters, thereby providing some means of civil recourse for duped investors, and some incentive for greater disclosure by corporation organizers. For example, in Dickerman v. Northern Trust Co., 176 U.S. 181 (1900), the U.S. Supreme Court wrote that a corporate promoter, which it defined as one who "brings together the persons who become interested in the enterprise, aids in procuring subscriptions and sets in motion the machinery which leads to the formation of the corporation itself," must be "treated as standing in a confidential relation to the proposed company, and is bound to the exercise of the utmost good faith." The promoter, the Court went on, "is the agent of the corporation and subject to the disabilities of an ordinary agent. His acts are scrutinized carefully, and he is precluded from taking a secret advantage of the other stockholders. . . . [and] must faithfully disclose all facts relating to the property which would influence those who form the company in deciding upon the judiciousness of the purchase."
Promoter liability cases such as Dickerman faded away in the aftermath of federal securities laws and state blue sky legislation mandating comprehensive disclosure to investors. Or so I thought, until I read a surprising decision handed down by a Manhattan appeals court earlier this month, in Roni LLC v. Arfa, 2010 NY Slip Op 04700 (1st Dept June 3, 2010), in which the court held that the organizer of a New York limited liability company
is a fiduciary of the investors it solicits to become members. The fiduciary duty includes the obligation to disclose fully any interests of the promoter that might affect the company and its members, including profits that the promoter makes from organizing the company. [Citations omitted.]
The decision affirmed a lower court ruling dated April 17, 2009, by New York County Commercial Division Justice Charles E. Ramos. The ruling stems from a hydra-headed litigation (read here my prior post concerning a related suit) between a group of Israeli investors and several New York based real estate developers who solicited them to invest in a series of LLCs formed to acquire, renovate, manage and ultimately resell two dozen or so residential apartment buildings located in upper Manhattan and the Bronx. The plaintiff investors claimed fraud and breach of fiduciary duty based on the defendants' alleged failure to disclose, prior to the formation of the LLCs and before plaintiffs acquired their membership interests, that the defendants stood to gain over $6.5 million in "commissions" paid by the property sellers and mortgage brokers.
The defendants moved to dismiss the amended complaint (read here) for failure to state valid claims, among other grounds. The lower court denied the motion as to the fiduciary breach claim on two, separate bases. First, it held that the plaintiffs alleged facts sufficiently showing a "relationship of trust, confidence or superior knowledge or control" between the plaintiff investors and the defendant "promoters," coupled with allegations of false representations by defendants. Second, it held that the defendants' mere status as LLC "promoters" imposed on them a fiduciary duty to disclose and be accountable for "secret profits derived from" the LLC's organization.
The appellate court disagreed with the first basis, concluding that the alleged personal relationships and disparity in real estate expertise were not sufficient to establish a fiduciary duty. "However," the court went on in upholding the second basis,
plaintiffs' allegations that the promoter defendants planned the business venture, organized the LLCs, and solicited plaintiffs to invest in them are sufficient to establish a fiduciary relationship.
The appellate court, as did the lower court, rested this first-of-its-kind holding on three ancient case authorities involving corporations, including the above-mentioned Dickerman, an even older New York state court decision, Brewster v. Hatch, 122 NY 349 (1890), and a 1920 U.S. Second Circuit decision, Gates v. Megargel, 266 F. 811 (2d Cir.), cert. denied, 254 U.S. 639 (1920). The appellate court also cited section 203(a)(iii) of the New York LLC Law which provides:
One or more persons may act as an organizer or organizers to form a limited liability company by . . . (iii) filing such articles, entitled "Articles of organization of ... (name of limited liability company) under section two hundred three of the Limited Liability Company Law," in accordance with section two hundred nine of this article.
Law Professor Larry Ribstein, who co-authors the leading LLC treatise and has been a vocal critic of New York LLC jurisprudence, writing for the Truth on the Market blog, called the Roni court's reliance on LLC Law section 203 "questionable," noting that it "merely provides for formation of the LLC, not for any duties of the organizers." His broader critique of the Roni decision is worth quoting at length:
There is no reason to think that the old corporate promoter cases were a better source of law on this issue than uncorporation law (see generally, Rise of the Uncorporation as to the uncorporate nature of LLCs). Indeed, it’s not even clear the old corporate cases are still good law for corporations. The uncertainties resulting from stretching the duty to disclose to the pre-formation period have now been replaced by federal disclosure law under Securities Act of 1933, which also applies to at least some LLCs.
The case may have been correctly decided because it’s possible the complaint alleged a misrepresentation which would be actionable without implying a fiduciary duty. But the court’s reasoning using hoary old corporate promoter cases to create a pre-formation fiduciary duty to disclose in LLC cases promises to make a mess out of NY LLC law. It also creates significant problems for business people who now have a fiduciary duty, with uncertain disclosure duties, imposed on what the court itself recognized is basically an arms’ length market relationship. It’s not even clear how parties can contract out of this duty, since the whole problem is that they do not yet have a contract.
It seems the only way NY business people involved in business formation can avoid this problem is simply to avoid New York.
Roni also raises serious issues of judicial deference to legislative prerogative in the policy arena. New York's LLC Law essentially assigns an LLC "organizer" -- the term "promoter" does not appear in the statute -- the ministerial task to form the entity by filing with the Department of State bare-bones articles of organization stating the LLC's name, the county in which it does business, and designating an agent for service of process. Under section 203(b), the organizer need not even be a member of the LLC. Unlike a corporation's certificate of incorporation, the LLC articles do not establish number of shares or par value. Rather, the LLC's capitalization and all other organizational provisions are left to the written operating agreement required by Section 417 of the LLC Law. Under section 417(c), the operating agreement may be entered into even before the LLC is formed, and "shall" set forth all provisions concerning the LLC's business, the conduct of its affairs, and the "rights, powers, preferences, limitations or responsibilities of its members, managers, employees or agents, as the case may be." Under the same section, the operating agreement may eliminate or limit the liability of managers and members "for any breach of duty in such capacity," subject, however, to the manager's mandatory duties of good faith and due care under section 409.
Given this fairly comprehensive legislative scheme, the question Roni poses, apart from the doctrinal and practical problems identified by Professor Ribstein, is whether (1) a court should use its common law authority to impose a status-based fiduciary duty on a class of persons, called "promoters," that the statute does not acknowledge, (2) in favor of a class of persons also not acknowledged by the statute, i.e., potential members of the LLC, (3) to expand protection beyond that already provided by common law remedies for fraud and the "special knowledge" branch of fiduciary law, (4) in order to create a new remedy arguably at odds with the intent of the LLC Law to require parties via the operating agreement to contractually allocate risk and reward as between those who manage the LLC and those who don't.
These are weighty issues, deserving of review by New York's highest court, the Court of Appeals.
Following Delaware Precedent, New York Appeals Court Rules that Indemnification of LLC Managers for Successful Defense in First Action Need Not Await Resolution of Second, Related Litigation
A little over a year ago, in the Ficus Investments case, the Manhattan-based Appellate Division, First Department, looked to Delaware case law for guidance in holding that an LLC manager named as defendant in an action brought by a member alleging conversion and fiduciary breach was entitled to advancement of his legal defense costs notwithstanding preliminary injunction rulings against him. (Read my prior post on Ficus here.)
Last month, in 546-552 West 146th Street LLC v. Arfa, 2010 NY Slip Op 01416 (1st Dept Feb. 18, 2010), the First Department again looked to Delaware precedent in another ruling of apparent first impression involving indemnification rights in the LLC internal warfare context. The issue this time: Is the defendant LLC manager entitled to indemnification for winning the non-merits dismissal of Action No. 1 prior to the adjudication on the merits of Action No. 2 asserting the same or similar claims? The Delaware Chancery Court answered "yes", and now so too does the First Department.
The Arfa litigation saga begins in 2006, when several real estate holding LLCs sued their former managers for failing to make certain disclosures to the LLC members when they were being solicited to invest in the LLCs. In February 2007, Manhattan Commercial Division Justice Charles E. Ramos dismissed the case on the ground that the LLCs lacked standing to pursue the claims, which properly belonged to their members. In September 2008, the First Department rejected the LLCs' appeal in a decision reported at 54 AD3d 543 (1st Dept 2008).
Meanwhile, even before the appeal was decided, the law firm that initiated the first suit on behalf of the LLCs started a second lawsuit on behalf of the members asserting the same claims against the managers. The second case remains pending.
Shortly after the First Department's affirmance, the former managers moved for indemnification of the legal fees they incurred in the first action pursuant to §420 of the New York LLC Law and the LLCs' operating agreements whose indemnification provisions tracked the statute.
In a ruling made from the bench on November 24, 2008 (read transcript here), Justice Ramos agreed that the former managers had satisfied the statutory and contractual requirements for indemnification, given that they had successfully moved to dismiss the LLCs' claims on the pleadings. But he denied the motion without prejduce on the ground that it was not ripe. Specifically, Justice Ramos ruled that, until the pending lawsuit against the former managers by the LLCs' members was resolved, he could not decide whether the former managers were entitled to indemnification with respect to the dismissed action brought by the LLCs. In other words, if the former managers were found to have engaged in wrongoing in the pending litigation brought by the LLCs' members, the former managers would not be entitled to indemnification for the fees they incurred in successfully dismissing the LLCs' lawsuit.
Last month, the First Department issued a decision reversing Justice Ramos and ordering that the former managers' indemnification motion be granted. According to the court:
That claims for the same alleged wrongdoing remain pending in a parallel action brought by the investors does not impair defendants' entitlement to the indemnification they seek. We interpret the indemnification provision (§6.8) in the LLC operating agreements, that substantially tracks the statute authorizing payment of expenses to managers regarding "any and all claims and demands whatsoever" (Limited Liability Company Law § 420), to require indemnification upon the resolution of the action or proceeding for which indemnification is sought. To make defendants wait until all of the related claims against them are resolved would eviscerate the right to indemnification . . .. The award of indemnification need not await a finding that defendants were free of misconduct. [Citations omitted.]
In deciding this issue of first impression, the First Department cited the Delaware Chancery Court's decision in Stockman v. Heartland Industry Partners, L.P., 2009 WL 2096213 (Del. Ch. Ct. July 14, 2009). There, the former fiduciaries of a limited partnership sought indemnification of their legal fees from the limited partnership after a federal criminal proceeding against them was dismissed without prejudice prior to a trial on the merits. The limited partnership refused to indemnify them, arguing that the request was premature, i.e., the former fiduciaries' eligibility for indemnification was dependent on the outcome of the civil action challenging their standard of conduct. Vice Chancellor Strine's decision for the Chancery Court rejected this argument and held that the former fiduciaries did not have to wait until the related pending civil litigation against them had been resolved in their favor before the limited partnership had to indemnify them for the fees they incurred in the already dismissed criminal action. “To do otherwise," VC Strine wrote, "would be the same as requiring indemnitees to wait for all proceedings against them arising from the same set of operative facts to be concluded before receiving indemnification for any of them, which this court has held to be improper in similar circumstances.” Id. at *11.
The Stockman decision in turn relied on prior Chancery Court decisions involving indemnification of corporate directors in Levy v. Hayes Lemmerz International, Inc., 2006 WL 985361 (Del. Ch. Ct. Apr. 5, 2006) (indemnification for settled class action granted prior to resolution of related SEC investigation), and Zaman v. Amedo Holdings, Inc., 2008 WL 2168397 (Del. Ch. Ct. May 23, 2008) (indemnification for non-merits dismissal of federal civil action granted prior to resolution of related state court action), where the courts emphasized the important role of indemnification in securing qualified persons to serve on corporate boards.
As I've noted before, advancement and indemnification of litigation expenses in disputes between company co-owners and managers can decisively tilt the playing field, whether it's because the party seeking reimbursement cannot afford legal counsel otherwise, and/or because the indemnifying party is compelled to foot the adversary's legal expenses as well as his or her own expenses. The First Department's Arfa decision gives a boost to defendants seeking indemnification in the not infrequent scenario involving multiple, related litigations.
Fiduciaries, the Duty to Disclose and the Incredible Shrinking Release
As a matter of public policy, we want people to settle their disputes without resort to courts. Enforceability and finality are the twin pillars of settlements. General releases in settlement agreements advance the goals of dispute resolution by encouraging due diligence by the releasor and by fixing the releasee's exposure.
The law of fiduciaries can complicate dispute resolution among business partners, and occasionally clashes with the settlement goals of enforceability, finality, diligence and certainty.
I wrote about such a clash earlier this year in the case of Littman v. Magee (read here). In Littman, an appellate court permitted a damages suit by a minority member of an LLC, brought over a year after he sold his interest to the controlling members allegedly at an artificially low price, to recover the "true value" of his interest based on financial information allegedly withheld from him at the time of sale. The court refused to give effect to a general release in the buyout agreement, expressly covering claims known and unknown, citing the controlling members' fiduciary duty to disclose all material facts bearing on the transaction. As I wrote at the time, Littman struck me as "lowering the bar" for claims of tainted buyout by former business partners.
A recent trial court ruling in a case called Arfa v. Zamir illustrates the Littman rationale's potential reach beyond the buyout context, and raises new questions about the utility of releases in out-of-court settlement agreements between business partners.
Arfa is a convoluted, multi-layered litigation among the controlling members of a series of real estate holding companies organized as LLCs, outside investors who intervened in the case, and a court-appointed temporary receiver. The case is assigned to New York County Commercial Division Justice Charles E. Ramos who wrote a helpful summary of the factual background in an earlier decision dated September 8, 2008 (21 Misc3d 1101(A)).
The plaintiffs, Rachel Arfa and her husband, Alexander Shpigel, filed a 54-page Second Amended Complaint which includes a Fifth Cause of Action for fraud against defendant Gadi Zamir relating to one of the realty venture's acquisitions known as Academy Street. The plaintiffs allege that in late 2004, Zamir recommended that the parties acquire Academy Street based on various income and expense projections, and that in reliance on Zamir's recommendation and presentations they approved the deal which closed in April 2005. Plaintiffs allege that in the summer of 2005, they learned of serious problems with the building's physical condition which allegedly were known to Zamir and withheld from plaintiffs at the time Zamir solicited their approval.
Meanwhile, plaintiffs and Zamir entered into a Governance Agreement dated June 9, 2005, which was intended to resolve growing frictions between them over management and control of the entire real estate portfolio. The plaintiffs allege that they "reluctantly agreed" to Zamir's "demand" that they enter into the Governance Agreement "to appease Zamir and prevent him from destroying the value of the real estate portfolio . . .." Mutual veto power over management decisions appears to be the main thrust of the Governance Agreement. The Governance Agreement also contains a mutual general release in which the parties release one another from "any and all claims . . . known or unknown" arising from events that pre-date the Governance Agreement.
Zamir moved to dismiss the fraud claim based on the release. As summarized in Justice Ramos's decision denying the motion dated December 8, 2008 (2008 NY Slip Op 33348(U)), the plaintiffs argued that
to the extent that Zamir owed Plaintiffs a fiduciary duty by virtue of being co-managers, he may not rely upon the Release to insulate himself from liability where he intentionally concealed from Plaintiffs the physical condition of the Academy Street Property, and which misrepresentation was an inducement to enter into the release from the outset.
Justice Ramos agreed with plaintiffs, citing Littman for the proposition that "a fiduciary cannot, by a general release, insulate itself of its fiduciary obligation of full disclosure by wrongfully withholding the very information that a party requires to make a reasoned judgment on whether to agree to the general release at the outset." The decision continues:
As a fiduciary, Zamir was under an affirmative duty to disclose any information that could reasonably bear on Plaintiffs' consideration to enter into the general release (Littman, 54 AD3d at 18). Accepting the [Second Amended Complaint's] allegations as true, as the Court must do at this stage, Zamir failed to disclose to Plaintiffs vital material facts in order to permit them to make a reasoned judgment as to whether to agree to the terms of the Release. In addition to failing to disclose to Plaintiffs, it is alleged that Zamir intentionally concealed from Plaintiffs material facts, including the engineering reports' findings concerning the structural defects in the property, and the Violations Undertaking.
I don't know whether the plaintiffs were facing potential claims by Zamir when they executed the Governance Agreement with mutual general releases. In any event, I have to assume that Zamir bargained for the release as part of the consideration for whatever concessions he made in the Governance Agreement. Had he understood that the release would not shield him from future claims based on alleged nondisclosures concerning Academy Street or any of their other real estate projects, would he have entered into the Governance Agreement? Obviously I can't answer the question or speculate whether it would have induced him to make additional disclosures that may or may not have soured the deal. The broader question, which I'll also leave for others to answer, is whether it makes sense, and at what cost to public policy favoring out-of-court settlement, to expand the fiduciary exception to enforcement of general releases based on an intrinsically amorphous duty of disclosure.
Update July 19, 2010: The First Department handed down two decisions in June and July 2010 significantly pruning Littman's broad pronouncements. One of those decisions reverses the lower court's Arfa ruling discussed above. Read here the first of two posts on the subject, highlighting the First Department's decision last month in the Centro Empresarial case.
Update July 29, 2010: Read here the second post discussing the First Department's July 13, 2010, decision reversing Justice Ramos's above-discussed ruling in Arfa.
