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.
The Importance of Identifying Your Client -- And Who's Not Your Client -- When Preparing Shareholder Agreements
You're an attorney. You're approached by Mortimer who tells you that he recently formed a new business corporation with Archibald, and that they want to hire you to prepare a shareholders' agreement. You also learn that Mortimer is the 51% "money" partner while Archibald is the 49% operating partner.
You've prepared many a shareholders' agreement, and you know that the interests of Mortimer as majority owner and Archibald as minority owner inherently are in conflict on diverse management and financial issues, not to mention restrictions on stock transfer and redemption. Should you represent both Mortimer and Archibald, or only one of them? The disparate financial wherewithal and contributions of the two partners only accentuates the conflict. If you represent Mortimer alone, and Archibald has no attorney of his own, is that a problem?
The rules of professional ethics set forth standards and proscriptions governing the simultaneous representation of multiple clients with conflicting interests. Under the right circumstances, with appropriate client counseling and disclosure, it may be ethically acceptable to represent both Mortimer and Archibald in the preparation of the shareholders' agreement. In all events, it is vitally important that the attorney identify and document exactly whom they're representing -- and whom they're not representing -- in these situations. The lawyer who fails to do so is taking on risk of a subsequent lawsuit by a disappointed shareholder for malpractice or fiduciary breach.
That's pretty much what happened in Schlissel v. Subramanian, 2009 NY Slip Op 52188(U) (Sup Ct Kings County Oct. 26, 2009), decided by Kings County Commercial Division Justice Carolyn E. Demarest. The plaintiff, Schlissel, and the defendant, Wasan, decided to buy a Dunkin' Donuts franchise in Brooklyn. Wasan, the money partner, was to own 75% and Schlissel the remaining 25% in consideration of past services and for helping Wasan legalize the franchise. In early 2002, Schlissel contacted attorney Van Epps to form a new corporation to acquire the franchise. Van Epps' initial engagement letter named Wasan as the client and made no mention of Schlissel. Some months after forming the corporation Van Epps also prepared bylaws, stock certificates and tax documents reflecting the 75%/25% ownership, which Schlissel and Wasan jointly executed. In this same time period Van Epps met with Schlissel on at least two occasions in connection with setting up the corporation.
In early 2003, Van Epps proposed to Wasan (but not to Schlissel) that Wasan capitalize the company with $725,000 of which about $90,000 would be loaned to Schlissel for her contribution while reducing her ownership to 12.5%. Wasan agreed. Van Epps prepared a shareholders' agreement, new stock certificate and promissory note, all dated "as of" February 1, 2003, reflecting Wasan and Schlissel as 87.5% and 12.5% shareholders, respectively. Van Epps sent the documents to Wasan with a note stating that he should
review this [shareholders'] agreement with Jeanne Schlissel and advise if any additional changes are required. As I mentioned in our meeting, Jeanne should hire an attorney to review this agreement and the note on her behalf.
Van Epps also prepared another engagement letter dated February 5, 2003 to be signed by Wasan as the client and by Schlissel as consenting to Van Epps' representation of Wasan. The letter stated:
I am pleased to represent you in connection with the preparation of a shareholders agreement for Tim & Tab Donuts, Inc.
[After stating the terms of the engagement, the letter continued:] If you agree with the foregoing terms, please indicate by signing below and returning a copy of this letter to me at the above address. Please ask Jeanne Schlissel to sign below indicating her approval of my representation of you.
Immediately above the signature line reserved for Schlissel, the letter stated:
With my signature below, I hereby consent to your representation of [Wasan] in connection with the preparation of a Shareholders Agreement for Tim & Tab Donuts, Inc. and other matters when and as requested by him.
Schlissel and Van Epps disputed the timing of these events. According to Schlissel's complaint, Wasan brought the corporate documents to her home on February 1, 2003, where she signed them. Schlissel contended that she signed the corporate documents "without having the opportunity to discuss them with Van Epps" because she believed that
as my attorney Mr. Van Epps was protecting my interests. At no point prior to my execution of the [corporate documents], did Mr. Van Epps communicate with me in any manner concerning these documents, in no way did he suggest that any material change in the corporation was occurring, nor did he remotely hint that a notable change effecting [sic] me was in view.
Several days later, she further alleged, she received the February 5 engagement letter and also got a "curt" phone call from Van Epps telling her that he no longer represented her and that this was "in her best interests".
Van Epps contended that Schlissel signed the corporate documents after she signed the February 5 engagement letter, and he denied having the telephone conversation.
Approximately five years later -- apparently, Schlissel's annual K-1 tax forms until 2008 continued to show her with a 25% interest -- Schlissel sued Wasan and Van Epps, among other claims, for breach of fiduciary duty in connection with the dilution of her stock interest from 25% to 12.5%. As summarized by Justice Demarest, Schlissel asserted that Van Epps "unilaterally advanced Wasan's interests over those of plaintiff, that he prepared certain corporate documents for the purpose of diluting and diminishing plaintiff's interest in [the company], and that he concealed material information from plaintiff concerning the adverse contents of these documents."
Van Epps moved to dismiss the claim, arguing that he was not Schlissel's attorney and therefore owed her no fiduciary duty. He pointed to the initial 2002 engagement letter which stated that Wasan was his client and, by implication, that he was not representing Schlissel. Justice Demarest observed that "[t]here is no set of rigid rules that must be followed to form an attorney-client relationship" which "may exist without an explicit retainer agreement or payment of fee." Rather, the "court must look to the actions of the parties to ascertain the existence of such a relationship . . . bearing in mind that plaintiff's unilateral belief does not confer upon her the status of defendant's client."
Applying this standard, and assuming the truth of Schlissel's allegations for purposes of a motion to dismiss, Justice Demarest found that Schlissel "had reason to believe" Van Epps was her attorney based on the fact that she was the one who first sought him out, her multiple meetings with Van Epps in 2002, and Van Epps' preparation of the initial corporate and tax documents signed by Wasan and Schlissel in April and May 2002.
Van Epps alternatively argued that any attorney-client relationship he had with Schlissel terminated when she counter-signed her consent on the February 5, 2003 engagement letter with Wasan. Justice Demarest disagreed, for two reasons. First, Van Epps' allegation, that Schlissel signed the shareholders' agreement and related documents after expressly consenting to his retention by Wasan, was contradicted by Schlissel's affidavit, and thus raised an issue of fact not resolvable on a motion to dismiss.
Second, under Rule 1.9 of the Rules of Professional Conduct, Van Epps was required to get Schlissel's "informed consent, confirmed in writing," before he could terminate any pre-existing attorney-client relationship with Schlissel while continuing to represent Wasan's interests adverse to Schlissel. According to Justice Demarest,
[t]he cursory "consent" signed by [Schlissel] does not evidence the requisite informed consent to overcome the edict of the Rule. There is no claim that Van Epps met with [Schlissel] or specifically advised her of the conflict of interest implicated in the proposed representation of Wasan alone.
Justice Demarest accordingly denied Van Epps' dismissal motion, finding that Schlissel's complaint "sufficiently alleges that Van Epps represented conflicting interests at the time [Schlissel] signed the corporate documents" and damages resulting from "alleged misconduct by [Van Epps] by his alleged simultaneous representation of adverse interests." Justice Demarest also was careful to note that the "court makes no determination concerning the merits of [Schlissel's] claims, as the motion to dismiss was addressed solely to the sufficiency of her pleadings and affidavits."
New York's highest court, in Matter of Kelly v. Greason, 23 NY2d 368, 375 (1968), opined that an attorney-fiduciary "is charged with a high degree of undivided loyalty to his client." In an earlier decision by Justice Demarest, which she cites in Schlissel, she expanded on that principle in the conflicts setting as follows:
An attorney has a fiduciary obligation to bring to his or her client's attention all relevant considerations when recommending a course of conduct. An attorney who fails to disclose a conflicting representation or circumstance that causes him or her to represent a client with diminished rigor, breaches his or her fiduciary duty to his or her client. (Macnish-Lenox, LLC v. Simpson, 17 Misc 3d 1118 [A], 2007 WL 3086028, *7, 2007 NY Slip Op 52055 [U] [Sup Ct Kings County 2007])
It is not at all unusual for business partners to prefer using a single attorney to set up a new business entity and prepare owner agreements. The level of trust between the partners typically is high at the outset, and the cost of multiple attorneys may be prohibitive. The partners also may be unaware of the conflicting interests involved in putting together a shareholders' agreement. Schlissel is a strong reminder to attorneys who take on such assignment, as the only attorney on the scene, that they should explicitly and unambiguously document who it is they do and don't represent, that if they do undertake joint representation they should carefully explain the potential conflicts and make a record of the same, and that they should obtain the written acknowledgment of any non-represented owner before they undertake legal services that, absent such acknowledgment, could reasonably be perceived as acting on behalf of all.
