With a Whimper, Not a Bang: New York's Top Court Rules on LLC Promoter Liability
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One of the benefits of writing a law blog is getting to know and exchange ideas, case notes and legal tidbits with other lawyers and academics. I am grateful that in this fashion I got to know Professor Larry Ribstein, who passed away unexpectedly last weekend at the peak of his prolific, dazzling career as a leading academic voice and mentor to many in diverse fields of business law and particularly in the area of unincorporated business entities. He had a giant intellect and a forceful style that pulled no punches. He was, as I described him to others, scary smart. Two years ago, on the occasion of the publication of his brilliant book, The Rise of the Uncorporation, he graciously agreed to be interviewed for this blog (read here). His last message to me was an email forwarding a post he wrote about the New York Court of Appeals' decision last week in the Roni LLC v. Arfa case discussed below, in which with typical and well-earned bravado he credits his amicus brief filed in that case with influencing the outcome. Undoubtedly, his influence and legacy of provocative scholarship will be felt and carried forward by many for a long, long time. |
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Last week the judges of the New York Court of Appeals unanimously affirmed the Appellate Division, First Department's interlocutory order in Roni LLC v. Arfa denying a motion to dismiss investors' claim for breach of fiduciary duty against the organizers or "promoters" of a series of real estate holding limited liability companies allegedly for failing to disclose, prior to formation of the LLCs, millions of dollars in brokerage commissions to be paid to the promoters. Roni LLC v. Arfa, 2011 NY Slip Op 09163 (Ct App Dec. 20, 2011).
The First Department's controversial ruling held, by analogy to 19th century cases imposing fiduciary obligations on stock corporation promoters, that promoters of LLCs by virtue of their status as such also take on fiduciary duties of disclosure to prospective investors. Before reaching the issue, the court specifically found that the complaint failed to allege, as an alternative basis for finding a fiduciary duty, that the defendants possessed superior expertise or knowledge about the real estate transactions coupled with false representations concerning that subject, or that defendants' personal connections with the plaintiffs established a fiduciary relationship. (Read here my account of the First Department's decision.)
When the case was argued before the Court of Appeals last month (read about it here), a number of the judges' questions suggested discomfort with the First Department's status-based rationale for promoter liability, while others suggested an approach to the fiduciary question not tied to promoter status but instead based on the more traditional approach keyed to the defendants' control and domination over the pre-formation enterprise.
Those hoping for a big showdown on the status-based rationale adopted by the First Department will be disappointed to read the Court of Appeals' decision. Stating that a fiduciary relationship exists "when confidence is reposed on one side and there is resulting superiority and influence on the other," the Court holds that the plaintiffs' complaint adequately alleges that "defendants planned the business venture, organized the limited liability companies, solicited their involvement and exercised control over the invested funds." The Court explains further:
We agree with plaintiffs that the promoters of a limited liability company are in the best position to disclose material facts to investors and can reveal those facts more efficiently than individual investors, who would otherwise incur expense investigating what the promoters already know. In addition, the complaint alleges that the promoter defendants represented to the foreign investors that they had "particular experience and expertise" in the New York real estate market. Although the promoter defendants describe plaintiffs as "sophisticated prospective investors," the complaint paints a different picture, stating that they were "overseas investors who had little or limited knowledge of New York real estate or United States laws, customs or business practices with respect to real estate or investments." Moreover, plaintiffs contend that the promoter defendants assumed a position of trust and confidence, in part, by "playing upon the cultural identities and friendship" of plaintiffs. Accepting the totality of these allegations to be true, as we must at this early stage of the litigation, the complaint adequately pleads a fiduciary relationship.
Trust and confidence? Playing upon the friendship of plaintiffs? Didn't the First Department hold that the complaint failed to plead a fiduciary relationship on those bases? The Court of Appeals makes no mention of it, nor does it acknowledge the defendants' argument that the Court of Appeals lacks jurisdiction on an interlocutory appeal to upset the First Department's holding on those points.
And what of the First Department's holding based on promoter status? The Court essentially punts the question whether a promoter as such owes a fiduciary duty, writing in a footnote that "[b]ased on the foregoing analysis, we need not decide the question of whether the promoter defendants' status as organizers of the limited liability companies, standing alone, was sufficient to allege a fiduciary relationship."
The late Professor Ribstein, who filed an amicus brief in the case supporting defendants' position, commented in one of his last blog posts that "the Court of Appeals, without saying so directly, effectively rejected the lower court’s determination that the complaint had not alleged a fiduciary relationship. The Court did so in order to avoid a holding in favor of promoter liability that would, I argued, 'make a mess out of NY LLC law.'" Professor Ribstein also took satisfaction from another footnote in the Court of Appeals' decision:
In its opinion, the Court recognized (n. 1) that “[c]ertainly, there are differences between limited liability companies and traditional corporations, but the distinctions are not relevant to the allegations in this case.” They were not relevant because the Court strained to accept the alternative basis for a fiduciary duty the lower court had rejected. In short, I invited the Court not to wreck NY LLC law by imposing open-ended pre-formation promoter liability. The Court accepted my invitation although this forced it to weave a circuitous course around the lower court’s opinion.
Doubtless there's some future plaintiff out there who, undeterred by the Court of Appeals' inconclusive handling of the issue, will bring another LLC promoter liability case based solely on promoter status. And when that happens, we shall see if Professor Ribstein's assessment proves correct.
Update January 6, 2012: Read here Doug Batey's take on the Roni decision.
NY's Top Court Hears Argument on LLC Promoter Liability
On November 15, 2011, the spectacular Albany courtroom pictured at left was the setting for oral argument before the New York Court of Appeals in Roni LLC v. Arfa, No. 228, in which the court is poised to decide whether pre-formation limited liability company "promoters" have a fiduciary duty of disclosure to potential investors. The outcome could have a significant impact on investment structure and investor solicitation, especially in the real estate industry where the LLC, for tax and other reasons, is the preferred form of business organization.
The case involves claims by a group of Israeli real estate investors who purchased membership interests in a series of LLCs formed to acquire, renovate, manage and eventually re-sell multi-family residential properties in New York City. The complaint's gravamen is that the defendants, who identified the properties, solicited investors, organized the LLCs, negotiated the acquisitions and obtained mortgage financing, concealed from the plaintiffs certain "brokerage" fees of up to 15% that the defendants were to receive from the property sellers and mortgage brokers, eventually exceeding $6.5 million. The plaintiffs alleged that the defendants as "promoters" of the to-be-formed LLCs had a fiduciary duty to disclose the brokerage arrangement to the plaintiffs as prospective investors, and that the fees inflated the purchase prices paid for the properties to plaintiffs' financial detriment.
The trial court denied defendants' motion to dismiss the complaint. In a June 2010 decision which I reported on here, the intermediate appellate court held that the complaint's allegations did not state a traditional claim for breach of fiduciary duty based on a business or personal relationship of trust and confidence, superior expertise and knowledge. The court nonetheless upheld the denial of the defendants' dismissal motion based on the defendants' "status as the organizers of the business venture", explaining as follows:
[P]laintiffs' 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. It is well settled that both before and after a corporation comes into existence, its promoter acts as the fiduciary of that corporation and its present and anticipated shareholders. By extension, the organizer of a 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. Accordingly, plaintiffs stated a cause of action for breach of fiduciary duty by alleging that the promoter defendants failed to reveal that they would receive commissions from sellers and mortgage brokers in addition to their other, disclosed, profit from the venture. [Citations omitted.]
The Briefs
In September 2010, the intermediate appellate court granted the defendants' motion for leave to appeal to the state's highest court, the New York Court of Appeals.
The defendants' brief filed in the Court of Appeals (read here) argues:
- the 19th century case authorities relied on by the lower court, involving promoters of corporations, did not establish a per se rule that promoters were fiduciaries as a matter of law;
- those authorities require a relationship of trust and confidence which the lower court expressly found lacking in Roni; and
- even if the old authorities did create a status-based rule for corporation promoters, it should not be applied to persons who organize LLCs.
The last point contrasts the discretion and control exercised by corporation organizers in creating the initial governance structures (i.e., articles of incorporation and bylaws) and deciding how to use investor money, with the contract-based LLC form in which governance and capital structures are set forth in written, fully integrated operating agreements executed by the investors.
The plaintiffs' opposing brief (read here) argues:
- the defendants' control of the investors' funds and management of the enterprise in the period prior to formation of the LLCs give rise to a fiduciary duty of disclosure of "hidden commissions";
- the common law rules governing corporation promoters as a matter of legal theory and policy should extend to LLC promoters; and
- in the alternative, the intermediate appellate court erred in holding that the complaint failed to allege a fiduciary relationship based on the defendants' special knowledge and real estate expertise coupled with the defendants' solicitation of overseas investors through personal relationships and "cultural affinity".
Professor Larry Ribstein, a leading authority on LLC and partnership law, filed an amicus brief in support of the defendants' position (read here), in which he argues:
- the intermediate appellate court's holding in favor of fiduciary duty of disclosure of organizers of LLCs is unprecedented in the law of LLCs;
- the NY LLC Law's provisions governing organizers and managers do not support a status-based fiduciary obligation for the former; and
- the old corporate promoter cases, even if not made "dead letter" by federal and state securities laws, should not be applied to establish pre-formation duties in LLCs, among other reasons, because unlike corporations, LLCs are "creatures of contract" that do not present "a potential for abuse comparable to that of large business entities seeking capital from hundreds or thousands of small investors."
The Oral Argument
If you click here, you can view a video webcast of the oral argument in Roni held on November 15, 2011. But first, you'll need some navigational aid.
The Court of Appeals combined oral argument in Roni with a second case, Assured Guaranty (UK) Ltd. v. J.P. Morgan Investment Management Inc., No. 227, due to the circumstance that both cases raise issues involving a preemption defense under the anti-fraud provisions of New York's Martin Act governing the sale of publicly offered securities. The entire argument lasts an hour. If you'd like to view the Roni portion of the webcast, click on the first entry on the November 15 calendar and, once the video opens, advance to the 27 minute mark for argument by defendants' counsel immediately followed by plaintiffs' counsel until the 45 minute mark. Defendants' counsel's rebuttal argument picks up at the 58 minute mark and goes just a few minutes to the end of the session. In the summary that follows, numbers in parentheses refer to the minute and second marks in the video.
Four of the six judges who heard the argument (Judge Smith recused himself) questioned the attorneys in Roni, with Chief Judge Lippman being the most active inquisitor. Early in defense counsel's argument (28:20), Judge Lippman set a somewhat skeptical tone with the questions, "What is the fact that it's an LLC have to do with the fiduciary duty issue?" and "Why should LLCs be treated differently?" to which defense counsel answered, LLCs are based on contractual relations established by the parties in the operating agreement and, therefore, at the pre-formation stage there is no point at which one can say the fiduciary relationship begins and ends.
Judge Graffeo queried (29:15) if the intermediate appellate court "went too far" in drawing such a close comparison between the corporate realm and LLCs, with which defense counsel readily agreed, stating that absent allegations of a relationship of trust and confidence, superior skill and knowledge, there can be no fiduciary obligation imposed on a promoter of a corporation or an LLC, and if there's no fiduciary relationship, the promoter has no duty to disclose a pre-formation commission arrangement like the one in Roni.
Judges Graffeo (31:50) and Pigott (32:40) asked several questions focused on the adequacy of the complaint, and whether the plaintiffs in Roni sufficiently alleged for pleading purposes a fiduciary relationship based on the plaintiffs' foreign residence and their dependence on the real estate expertise of the defendants, to which defense counsel replied that, in an interlocutory appeal (as opposed to an appeal from a final judgment), the Court of Appeals lacks jurisdiction to review the intermediate appellate court's ruling that the complaint fails to plead the traditional badges of a fiduciary relationship.
Plaintiffs' counsel was met by questions from Judge Lippman (35:05) as to the basis for the alleged fiduciary relationship and if it matters "whether you're an LLC or not?" Plaintiffs' counsel replied that the business form does not matter ("not at the starting gate yet") and that the "control and domination" exercised by defendants over the pre-formation enterprise imposes fiduciary duties of disclosure.
Judge Ciparick asked (37:20) whether the purchase prices of the real properties were inflated by the secret commissions, to which plaintiffs' counsel answered "Yes, absolutely" and that the plaintiffs consequently suffered a direct, out-of-pocket loss.
Judge Graffeo then asked (39:30) whether an undisclosed commission, standing alone, creates a fiduciary relationship and, if other factors must be pleaded, whether the Court of Appeals has jurisdiction to review the finding below that the complaint did not adequately allege the traditional fiduciary badges. Plaintiffs' counsel responded that a claim based on undisclosed commission is stated where the promoters solicited investors, controlled the funds and controlled the properties, and that the Court of Appeals has jurisdiction to affirm the decision below on an alternative ground.
Judge Pigott next asked (41:50), "Is there any limit to this?" and "Can you bring a case similar to this on almost any set of facts in which someone is dissatisfied with the amount of the return they got?" Plaintiffs' counsel suggested in reply that such cases are limited to ones where the promoter sells the investment, controls the investment funds pre-formation, and where the alleged non-disclosure -- here, the $6.5 million in commissions -- is material to the decision to invest.
Judge Pigott then pressed counsel (43:25) to identify the source of the alleged fiduciary duty in Roni, to which plaintiffs' counsel replied that it stems from the defendant promoters' soliciting the investment, taking the investors' money, controlling the expenditure of the monies, hiring counsel for the enterprise, arranging financing for the acquisitions, and managing the properties, to which Judge Pigott responded (44:00), "That's kind of where I'm looking for the line drawing because if you have a situation where each one of those is a fiduciary obligation, each one could be a cause of action for breach of fiduciary duty."
In his rebuttal argument (58:00), defendants' counsel contended that his clients did not exercise control and domination over the investments, and that they were required to use investor funds in the manner specified in the written promotional materials provided to the plaintiffs. Judge Lippman asked (59:25), "What about the concealment of the 15% fee?" to which defendants' counsel replied that the defendants were not disputing concealment for purposes of the dismissal motion but that, without an independent basis for imposing a fiduciary duty, the concealed fees could not give rise to liability.
Will New York be the first state to adopt a status-based rule holding LLC promoters to a fiduciary standard? If not, will the Court of Appeals nonetheless affirm on the ground that the complaint adequately pleads a fiduciary relationship based on control and domination or, contrariwise, will it dismiss the fiduciary breach claim on the basis it has no jurisdiction to review the intermediate appellate court's conclusion that the complaint does not plead a fiduciary relationship other than based on the defendants' status as promoters?
We'll likely have to wait until the early months of next year for the answer, though that may also depend on how long the Court takes to decide the related appeal in the Assured Guaranty case. Indeed, if the Court in that case and in Roni holds that the Martin Act preempts the plaintiffs' common law claims, the LLC promoter liability issue in Roni likely will be mooted.
The Rise and Fall and Rise of Blue Chip: Fiduciary Duty Trumps Waiver in Latest First Department Decision
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Toward the close of its 2010-11 term, the New York Court of Appeals (the state's highest court) issued a pair of decisions in the Centro and Arfa cases that cast a dark cloud over a line of precedent established by the Manhattan-based Appellate Division, First Department, that had refused to enforce releases or fiduciary waivers given by sellers of interests in closely held businesses who later brought suit against the purchasers/controlling owners for concealing material information affecting the buy-out price, such as an impending deal to sell the company assets to a third party at a much higher valuation.
The best known of the First Department cases, Blue Chip Emerald v. Allied Partners, 299 AD2d 278 (2002), and its progeny including Littman v. Magee, 54 AD3d 14 (2008), broadly suggested that a fiduciary can never contractually relieve itself of its duty of full disclosure by withholding material information the non-controlling owner needs in making its decision to enter into the buy-out agreement. In Centro and Arfa, however, the Court of Appeals expressly disagreed with the First Department cases insofar as they would preclude a sophisticated party from giving a release or waiver in favor of its fiduciary as part of a transaction where the party understands that the fiduciary is acting in its own self-interest and the release or waiver is knowingly entered into. (Read here my post on the Centro and Arfa decisions.)
Anyone who thought Blue Chip was down for the count would be mistaken. Last week, over a vigorous two-judge dissent, a three-judge majority in Pappas v. Tzolis, 2011 NY Slip Op 06455 (1st Dept Sept. 15, 2011), unabashedly wielded Blue Chip to salvage a lawsuit brought by two owners of a realty company who, after selling their LLC membership interests to the third member under an agreement containing a fiduciary waiver, brought suit claiming the buyer intentionally concealed from them an impending deal to sell the company's sole asset to an outside buyer at a spectactularly higher valuation.
The Lower Court's Ruling
My March 2010 post about the trial court's decision in Pappas throwing out the complaint gives a full recital of the underlying facts. In brief, the three parties formed a member-managed Delaware LLC to hold a long-term net lease on a Manhattan commercial property, which they then subleased to one of the members, Tzolis, who subsequently stopped paying rent and then proposed that he acquire the other two members' interests. The deal was made for $1.5 million. Six months later, Tzolis as sole LLC member transfered the lease to a developer for $17.5 million. The two former members then brought suit against Tzolis for breach of fiduciary duty, fraud and other claims based on his alleged nondisclosure at the time of the buy-out of his concurrent negotiations with the developer who acquired the lease.
The trial court dismissed the complaint based primarily on the "Other Activities" provision in the LLC's operating agreement that authorized any member to "engage in business ventures and investments of any nature whatsoever, whether or not in competition with the LLC, without obligation of any kind to the LLC or to the other Members." The judge held that the provision eliminated Tzolis's alleged fiduciary duty of disclosure, as authorized under Section 18-1101(c) of Delaware's LLC Act as well as under New York law to the extent made applicable under the LLC agreement's choice-of-law provision. (Read here Professor Larry Ribstein's analysis of the choice-of-law issue in Pappas.)
The judge also accepted Tzolis's argument that the parties' intent to eliminate fiduciary duty under this provision was re-affirmed by a "Certificate" signed by the selling members as part of the buy-out agreement, stating that the sellers had performed their own due diligence, had engaged their own legal counsel, were not relying on any representation by Tzolis outside those made in the agreement, and that "each of the undersigned sellers agrees that Steve Tzolis has no fiduciary duty to the undersigned sellers in connection with [the sales of their interests]."
The Majority Opinion
Last week's appellate decision reversed the lower court and reinstated the complaint's central claims for fiduciary breach and fraud. (It's interesting to note that two of the three judges in the majority, Justices Saxe and Acosta, were on the panel that decided the Littman v. Magee case that, along with Blue Chip, came under attack in Centro and Arfa.)
The majority starts its analysis stating that, as the party seeking dismissal, Tzolis had the procedural burden of "clearly" establishing that the Other Activities provision "eliminated the particular fiduciary duty that plaintiffs contend he breached." The majority readily finds that, while the provision may have permitted Tzolis to pursue for his own benefit a competitive business opportunity unrelated to the LLC,
the provision does not "clearly" permit Tzolis to engage in behavior such as that alleged here, which was to surreptitiously engineer the lucrative sale of the sole asset owned by [the LLC], without informing his fellow owners of that entity.
The majority reaches the same conclusion under substantive Delaware law holding that "'unless the LLC agreement in a manager-managed LLC explicity . . . restricts or eliminates traditional fiduciary duties, managers owe those duties to . . . [the LLC's] members'" (quoting Kelly v. Blum, 2010 WL 629850, *10 (Del Ch 2010).
The majority devotes the greater part of its analysis to the effect of the Certificate's statements disclaiming plaintiffs' reliance on any representations by Tzolis and that Tzolis owed them no fiduciary duty. Stating that "[t]his Court addressed that very issue in Blue Chip . . . a case with very similar facts," the majority concludes that "we are compelled to act with the same uncompromising rigidity here as in Blue Chip." Notwithstanding the Certificate's disclaimers, Tzolis "had an overriding duty to disclose his dealings with [the developer] to plaintiffs before they assigned their interests in [the LLC] to him."
Arguably the most critical part of the majority's opininon is its treatment of the Court of Appeals' recent Centro and Arfa decisions in which, as noted above, the higher court seemingly gutted Blue Chip. Here's how the majority distinguishes the cases and narrows their import as regards the effect of the Certificate:
. . . Centro is distinguishable. In that case, the plaintiffs alleged that the defendants, their co-fiduciaries, induced them to sell their interest in a telecommunications company by misrepresenting the value of the enterprise. The Court of Appeals, in affirming the dismissal of the plaintiffs' fraud claim, noted that the "plaintiffs knew that defendants had not supplied them with the financial information necessary to properly value [their interest], and that they were entitled to that information . . . In short, this is an instance where plaintiffs have been so lax in protecting themselves that they cannot fairly ask for the law's protection'" (2011 Slip Op at *7, quoting DDJ Mgt., LLC v Rhone Group L.L.C., 15 NY3d 147, 154 [2010]). The Court further noted that the plaintiff "ha[d] actual knowledge that its fiduciary [was] not being entirely forthright" (id.). In contrast, defendants here have made no showing that plaintiffs had any reason to suspect Tzolis of deceit or that they had the independent ability to discover facts that would have deterred them from selling their interests in [the LLC] to him.
The majority dismisses as "irrelevant" Centro's and Arfa's disagreement with Blue Chip. In both of those cases, the majority says, prior to entering into the agreements including releases, the relationships between the co-owners had deteriorated to the point that, in Centro's words, "the fiduciary relationship is no longer one of unquestioning trust." The majority contrasts the facts in Pappas, where there is
no evidence that plaintiffs and Tzolis were not still in a relationship of unquestioning trust at the time of the transaction at issue, other than employing the circular logic that they must not have had such a relationship given that plaintiffs were willing to execute the certificate.
Finally, the majority also distinguishes the "exceedingly broad" releases given in Centro and Arfa that, unlike the language used in the Certificate, extinguished the defendants' liability "in all manner of actions . . . whatsoever . . . whether past, present or future . . . resulting from the ownership of membership interests in the entity . . .."
The Dissent
The first sentence of the dissent, written by Justice Helen Freedman and joined by Justice David Friedman, plainly states its thesis: "I would affirm the dismissal of the complaint in its entirety, because contractual disclaimers by plaintiffs preclude the causes of action that the majority has reinstated." (It's again interesting to note that Justice David Friedman wrote both of the First Department opinions upheld by the Court of Appeals in Centro and Arfa, while Justice Helen Freedman voted with the majority in Centro.)
It's unclear the extent to which the dissenters rest their position on the Other Activities provision in the LLC's operating agreement. All they say is that the provision "anticipated competing interests among the LLC members"; that it "afforded Tzolis latitude to pursue his individual business interests for his own gain regardless if his co-members' interests"; and that the restriction or elimination of fiduciary duty is permitted under Delaware law. The dissent does not directly lock horns with the majority's distinction between competitive activities involving business opportunities outside the LLC versus those involving the LLC's sole asset, and thus whether the provision standing alone eliminated the fiduciary duty of disclosure allegedly breached by Tzolis.
What is clear is the dissenters' reliance on the Certificate as an insuperable, contractual barrier to the plaintiffs' claims. Justice Freedman writes:
In this case, plaintiffs were business partners of Tzolis who affirmed at the closing and in connection with the assignments that they were represented by counsel and had performed their own due diligence in connection with the transaction. Their acknowledgment in the closing certificate that Tzolis was not acting as their fiduciary and that they were not relying on any representations by him beyond those contained in the closing documents, constituted fair notice that plaintiffs were engaging in an arm's-length business transaction with Tzolis, that they should not place their "unquestioning trust" in him, and that in exchange for their immediate and certain twentyfold return on their investment, they were forgoing the possibility of future greater profit.
The dissent calls "unpersuasive" the majority's attempt to distinguish Centro. Here's what Justice Freedman says:
It is immaterial that instead of signing a general release plaintiffs executed a certificate disclaiming Tzolis's fiduciary duty and his earlier representations. The disclaimer was tantamount to a release from all claims against Tzolis in connection with the assignment that were premised on his fiduciary duty to plaintiffs.
Lastly, Justice Freedman also challenges the majority's contention that Tzolis made no showing that plaintiffs lacked "unquestioning trust" in him, writing as follows:
The face of the closing certificate, however, indicates otherwise. In consideration of Tzolis's purchase, plaintiffs were presented with, and with the advice of counsel signed, an explicit acknowledgment that Tzolis was not their fiduciary and that they should not rely on his earlier representations. Even if plaintiffs had the right to place their trust in Tzolis before they signed the certificate, that right necessarily ended when they executed it. Accordingly, the breach of fiduciary duty claim is barred.
Next Stop, Court of Appeals?
Under New York appellate rules, since the decision reinstating claims does not finally determine the action, it does not appear that Tzolis has a right of appeal to the Court of Appeals based on the two-judge dissent under CPLR 5601[a]. Nonetheless, I would think there's a more than decent likelihood that the Appellate Division or Court of Appeals would grant permission to appeal. We bystanders can only hope Tzolis pursues and is granted such leave.
The wavering fortunes of Blue Chip reflect a fascinating tug-of-war between two schools of thought. On the one hand, there are what I'll call the judicial interventionists who believe it is the purpose and duty of the courts to use their powers of equity to enforce common law norms of behavior among business partners who owe each other, as Judge Cardozo put it in Meinhard v. Salmon, the "punctilio of an honor the most sensitive." On the other hand there are the contractarians who posit that the parties by and large are free to order their business relations as they see fit and that judicial policing should not extend beyond enforcement of the parties' agreements. The Delaware LLC Act, with its express invocation of the freedom-of-contract principle and its express authorization to eliminate fiduciary duty, creates an optimal vehicle for the latter school.
Of course, the New York Court of Appeals is not a debating society and, should the Pappas case come before it, it is likely to examine closely the facts alleged in the complaint and the precise language used in the parties' agreements to fashion a ruling that resolves the particular dispute on the narrowest possible grounds. As I see it, that narrow issue will be whether, under the analysis advanced in Centro and Arfa, Tzolis's reliance on the Certificate as a fiduciary waiver must be accompanied by extrinsic evidence of an already deteriorated relationship and loss of trust between the bargaining business partners, or whether the "mere" presence in the Certificate of disclaimers and a fiduciary waiver itself evidences the selling members' actual or constructive knowledge and acceptance of the risk that Tzolis was withholding material information concerning the value of the LLC's asset.
Professor Ribstein on last week's decision: Read here his lively take on the Pappas decision, in which he suggests among other things that neither New York nor Delaware law offers an adequate legal framework for contracting parties in such circumstances to clarify their intentions and fend for themselves in determining at what price to liquidate their ownership interests.
Rothko Damages Awarded for General Partner's Undervalued Buyout of Limited Partners' Interest in Realty Company
The basic storyline is familiar: Controlling owner of closely held company buys out interests of non-controlling owners who subsequently sue for breach of fiduciary duty and fraud after learning that the controlling owner soon thereafter sold the company or its assets to a third party at a much higher price, or that the company assets have a much higher valuation than previously represented.
The most prominent, recent cases of this kind, such as Blue Chip Emerald v. Allied Partners, Littman v. Magee and Centro Empresarial Cempresa v. America Movil, have focused primarily on the efficacy or not of releases and disclaimers in the buyout contracts, raised as defenses by the purchasing owner faction. New York's highest court, the Court of Appeals, likely will shed some additional light on the interplay of release and the fiduciary duty of disclosure when it issues its ruling in the Centro Empresarial case in the next month or so.
Meanwhile, the Appellate Division, First Department, last month handed down a notable decision in Frame v. Maynard, 2011 NY Slip Op 03335 (1st Dept April 28, 2011) (recalling and vacating the court's decision and order entered on November 18, 2010, reported at 78 AD3d 508), stemming from a suit against the general partner of a real estate limited partnership who misled the limited partners into selling him their interests at a price far below market value. The decision is of interest primarily because it directs an award of Rothko damages -- named after the New York Court of Appeals' decision in Matter of Rothko, 43 NY2d 305 (1977) -- calculated as the difference between the actual sale price and the value of the asset or interest at the time of the trial as opposed to the time of the transaction at issue. In Frame, the subject realty appreciated greatly between the conveyance of the limited partner interests in 2002 and the trial over five years later.
I can't improve on the summary of the facts in the appellate court's decision, so here it is:
Plaintiff Frame and defendant Maynard were the two general partners of a limited partnership (the Partnership), formed in 1980, to acquire and operate a building at 5008 Broadway, and they acquired the underlying land as tenants in common. The eight limited partnership shares were acquired by Maynard, Guthrie, Paulson, Hines and others. Under the limited partnership agreement (the Agreement), the net proceeds of a sale or refinancing of the "Project," defined as the building, were to be split 60-40 between the limited partners and the general partners. Following a settlement agreement entered into in 1986, Frame conveyed his half-interest in the underlying land to the Partnership and resigned as general partner. The Agreement was amended to provide that Frame would receive 20% of the net proceeds of a sale or refinancing of the "real property in the Project," with the remainder to be split 25% to the general partner and 75% to the limited partners.
In May 2001, Maynard offered to acquire the limited partners' interest in the Partnership property for $842,427. Maynard provided schedules to the limited partners representing that the value of the building, based on its cash flow as shown in historical profit and loss statements, was $665,074 or $842,427, depending on the capitalization rate used. A majority of the limited partners consented to Maynard's proposed acquisition of the property, i.e., the building and the 50% ownership interest in the land owned by the partnership, on his own behalf or for a wholly owned entity.
However, Maynard did not disclose to the limited partners that, since March 2001, he had been negotiating with the Community Preservation Corporation (CPC) to obtain a mortgage loan on the property at 5008 Broadway from the Federal Home Loan Mortgage Corporation (Freddie Mac) in the proposed amount of $1,550,000. During those negotiations, Maynard provided CPC with "adjusted" historical profit and loss numbers, which supported the proposed loan amount. An appraisal prepared by an independent appraiser in connection with Maynard's loan application valued the building and land in the range of $2.2 million as of June 2001. In November 2001, Maynard sent checks in the amount of about $40,000 per share to the limited partners purportedly representing their share of the sale of the Partnership property.
On February 7, 2002, Maynard assigned his right to acquire the Partnership property to defendant 5008 Broadway Associates, LLC (5008 LLC) for nominal consideration, and a deed conveying the property to 5008 LLC was filed. On the same date, 5008 LLC received a mortgage loan from CPC in the amount of $1,485,000, leaving net proceeds of about $1 million. In late February, Maynard made an additional distribution to the limited partners of about $5,000 per share, purportedly representing final distribution of the Partnership's assets.
In June 2004, after a title search disclosed the 2002 conveyance, the former general partner, Frame, filed a complaint seeking to recover his 20% share of the net proceeds under the amended 1986 agreement. Several limited partners asserted cross claims against Maynard for constructive fraud and breach of fiduciary duty based on his false representations to them of the realty's value while failing to disclose the impending refinancing and $2.2 million June 2001 appraisal.
Following a 19-day bench trial before Manhattan Supreme Court Justice Paul G. Feinman, in October 2008 the court issued a 58-page Decision and Order After Trial and thereafter entered a judgment against Maynard. The judgment awarded Frame about $421,000 on his claim for breach of contract, representing 20% of the deemed net proceeds using a $2.9 million appraisal as of February 2002. The judgment also awarded two of the limited partners, on their claims for breach of fiduciary duty, amounts equal to the differential between what they received for their limited partner interests and the deemed value of their interests also based on the $2.9 million February 2002 appraisal.
The court's calculation of the limited partner awards excluded Maynard's one-eighth limited partner interest. All amounts awarded carried pre-judgment interest at 9% from February 2002.
The court's decision and the judgment also dismissed the claims of one limited partner, Hines, whom the court considered to be a "sophisticated investor who could have rather easily made further inquiry into the likelihood of the property value as represented by Maynard prior to consenting to the transaction" (Decision and Order, pp. 40-41).
Appeals and cross appeals followed as to liability and damages. In its decision, the appellate court notes its deference to the trial court's finding that Maynard "was not a credible witness," and it concludes that Maynard's denial of knowledge of the $2.2 million June 2001 appraisal was "at odds with common sense." The court also affirms the trial court's finding that Maynard breached his duty of "undivided and undiluted loyalty" by failing to inform the limited partners of his negotiation of a $1.5 million mortgage loan and concomitant valuation over $2 million. The limited partners, including Hines, justifiably relied on Maynard's misrepresentations of the realty's value. The appellate court also upheld the trial court's finding that Maynard breached Frame's contractual entitlement by failing to pay his 20% share of the sale proceeds.
The court's discussion of Rothko damages begins with a statement of the general rule for measuring damages when a fiduciary has sold property for an inadequate price, i.e., the difference between what was received and what should have been received, "so that the beneficiary of the fiduciary duty is placed in the same position he or she would have been in absent the breach." Rothko, however, created an exception to the general rule "where the breach of trust consists of a serious conflict of interest -- which is more than merely selling for too little." Thus, when a fiduciary engages in self-dealing, under Rothko the court can use an increased measure of damages based on the value of the subject asset at the time of the trial.
Obviously, the Rothko rule can greatly augment a plaintiff's damage award when the asset being valued appreciates at a rate higher than the pre-judgment interest rate (9%) between the transaction date and the time of trial which usually takes places many years later. In Frame, the trial court's Decision and Order refers to testimony by an appraisal expert called on behalf of one of the limited partners, stating that the estimated value of the realty in 2007, when the trial began, was $7.5 million or about two and a half times its value in February 2002.
The appellate court finds Rothko and the circumstances in Frame indistinguishable:
In both cases, the trial court found a breach of fiduciary duty as well as both constructive and actual fraud resulting from self-dealing by the fiduciaries. The Rothko Court described the conduct of the estate trustees as "manifestly wrongful and indeed shocking" (Rothko, 43 NY2d at 314). Maynard's conduct in the present case is no less improper, especially given that he repeatedly assured the limited partners that the price he was offering was generous while simultaneously negotiating for a mortgage that presupposed a far higher valuation for the Partnership property.
The appellate court nonetheless hands Maynard a small victory by holding improper the trial court's determination to exclude Maynard's limited partnership share from the calculation of the limited partners' damages. Since Maynard did not acquire his interest as a result of fraud or breach of duty, disregarding his share in calculating damages "leads to an unwarranted windfall" for the other limited partners.
The decision remands the case for further proceedings on damages in accordance with the opinion. By Order dated May 18, 2011, the trial court ordered an exchange of expert reports and set the matter down for a hearing on Rothko damages on July 7, 2011. If, as one expert already testified, the court determines that the realty had a $7.5 million value as of 2007 when the trial commenced, the damages due the limited partners by Maynard likely will increase twofold or more.
Lawyers Caught in the Crossfire of Shareholder Disputes
Woe unto the corporate counsel who gets caught in the crossfire of a nasty shareholder dispute.
Efforts to disqualify or even sue outside corporate counsel are not unusual when the opportunity presents itself in a corporate dissolution proceeding or other internal feud. (Read here my recent post on disqualification cases.) A critical, threshold question is whether the lawyer or law firm represents only the company or its principals as well. The answer determines to whom the lawyer owes a duty that might give rise to a conflict or an actionable breach.
In the realm of the closely held business entity, the general rule is that a lawyer's representation of the company does not make him or her a lawyer for the company's owners, managers or employees. The rule usually plays out in the setting of an application to disqualify company counsel based on alleged conflicting representation in a lawsuit amongst the company and a present or former owner, manager, etc., and it usually is found to prevail unless the lawyer expressly assumed an affirmative duty to represent the individual along with the company. A recent example of the rule's application is Monroe County Commercial Division Justice Kenneth R. Fisher's scholarly opinion denying a motion to disqualify company counsel in Bonn, Dioguardi & Ray, LLP v. ThomasYork, LLP, Dec. & Order, Index No. 2010/15130 (Sup. Ct. Monroe County Feb. 16, 2011).
The entity theory of representation, however, does not insulate corporate counsel against shareholder claims for alleged misconduct that lies outside the usual bounds of the attorney-client relationship. Take, for instance, the case of Aranki v. Goldman & Associates, LLP, 2011 NY Slip Op 30789(U) (Sup. Ct. Nassau County Mar. 22, 2011), a six-year litigation saga recently ended with a summary judgment of dismissal. Along the way, however, an appellate court reinstated claims against the law firm for "colluding" with the company's majority members to squeeze out the minority member of a limited liability company and for aiding and abetting a breach of fiduciary duty by the majority members.
The subject company in Aranki, called Millenium Alliance Group, LLC ("MAG"), was formed in 1998 as a joint venture between two existing insurance agencies and their owners. Plaintiff Fahmi Aranki and his agency held a combined 45% membership interest in MAG. Within a few years Aranki's relationship with the other members deteriorated as MAG's business prospects worsened, with each side accusing the other of financial improprieties. In 2003, the majority caused MAG to bring suit against Aranki and his separate agency for conversion, breach of fiduciary duty and a number of other claims. Aranki asserted mirror counterclaims against MAG and its controlling members. (Read here a more detailed description of the underlying facts and claims set forth in an August 2003 decision by Justice Leonard B. Austin, who now serves as an Associate Justice of the Appellate Division, Second Department, in which he denied dueling preliminary injunction motions.)
In May 2004, the parties reached a settlement of the litigation involving a buyout of Aranki's interest in MAG on undisclosed terms. The settlement, however, merely pulled down the curtain on Act One. Act Two began in March 2005, when Aranki filed a new lawsuit against MAG's outside general counsel and his law firm essentially alleging that the law firm had taken an improper partisan role on behalf of the majority against the minority, and asserting claims for malpractice, fraud, breach of fiduciary duty and breach of contract. Aranki's complaint alleged, among other things, that the law firm improperly advised MAG's Board to bring a baseless lawsuit (the 2003 action) against Aranki for theft of company property, and engaged in other collusive conduct with the majority designed to weaken Aranki financially and, ultimately, to force him to surrender his interest in MAG at a below-market price.
In September 2005, the trial court granted the law firm's pre-answer motion to dismiss Aranki's complaint in its entirety (read here). The court held that, as the attorney for the entity MAG, the law firm breached no duty owed to Aranki as minority member.
Aranki appealed. In a November 2006 decision reported at 34 AD3d 510, the appellate court reinstated two of Aranki's four claims, for malpractice and aiding and abetting breach of fiduciary duty, stating as follows (citations are omitted):
Although the complaint "fails to plead specific facts from which the existence of an attorney-client relationship, privity, or a relationship that otherwise closely resembles privity between the plaintiff [s] and [the defendants] may be inferred," the complaint in this case sets forth in sufficient detail facts which, if proven, would show that the defendants colluded with the majority members of Millennium Alliance Group, LLC (hereinafter MAG), inter alia, to freeze the plaintiffs out of MAG's management and profit sharing and force them to surrender, at a reduced price, their minority membership interest in MAG. Such allegations fall within the narrow exception of "fraud, collusion, malicious acts or other special circumstances" under which a cause of action alleging attorney malpractice may be asserted absent a showing of actual or near-privity.
Similarly, although the complaint fails to plead facts sufficient to establish that the defendants breached any fiduciary duty owed to the plaintiff, it does make out a cause of action against the defendants alleging aiding and abetting a breach of fiduciary duty by the majority members of MAG .
After a four-year lapse during which the parties engaged in pre-trial discovery, in December 2010 the law firm moved for summary judgment dismissing the remaining two claims. The decision last month granting the motion, by Nassau County Acting Supreme Court Justice Denise L. Sher, recounts key deposition testimony and evidence relied on by the parties, including Aranki's admission that although the law firm "would, on occasion, advise a course of conduct, it was left to [MAG's] Board of Managers to decide on whether to follow [its] advice." Based on this and other evidence Justice Sher concludes that:
Plaintiffs have failed to provide any admissible evidence establishing any conduct on the part of the defendants that was atypical for a corporate counsel and have failed to offer any expert testimony to establish the standard practices of a corporate attorney or explain how Goldman's giving of legal advice to MAG allegedly deviated from these norms.
Concerning the 2003 lawsuit against Aranki initiated by MAG allegedly upon the law firm's advice, the Court observes:
Moreover, the fact that principals of MAG, including the plaintiffs, entered into a global settlement ending the litigation between themselves demonstrates that the lawsuit was commenced in good faith and not frivolous.
Justice Sher also cites the 2004 "global" settlement in rejecting Aranki's claim against the law firm for aiding and abetting breach of fiduciary duty by the majority members. The settlement agreement contains a fairly standard provision in which all parties acknowledge that the agreement "is not to be construed as an admission of liability on the part of any of the parties, and each party in fact denies any wrongdoing or liability to the other." Here's what Justice Sher says about the provision:
Plaintiffs were represented by independent counsel of their own choosing when they voluntarily executed the stipulation acknowledging no admission of liability by any of the parties. Each party denied wrongdoing (such as breach of fiduciary duty) toward the others. If the plaintiffs did not want to execute the stipulation acknowledging that [the majority members] were not responsible or liable for any wrongdoing toward the plaintiffs, then plaintiff Aranki should have pursued the underlying litigation on its merits to establish as a matter of fact that there was a breach of fiduciary duty.
While there's no mention of it in the court's decision, presumably the 2004 settlement agreement included an exchange of general releases. Assuming that's true, what's unusual here is that the releases apparently did not define the releasees to include the parties' attorneys and other agents which is a fairly standard practice. For example, in a case involving similar circumstances called Berkowitz v. Fischbein, Badillo, Wagner & Harding, 7 AD3d 385 (1st Dept 2004), on a pre-answer motion to dismiss the court threw out claims against the law firm based on the general release's discharge of the principal and his "agents" -- which the court construed to include attorneys -- in any matter relating to the company that was the subject of a related buy-out agreement. Had the same thing been done in Aranki with the releases accompanying the 2004 agreement, the defendant law firm could have saved itself years of litigation trouble and expense.
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.
Update October 30, 2011: The First Department granted the defendants' application for leave to appeal to the Court of Appeals. The appeal will be argued on November 15, 2011. Professor Ribstein has filed a friend-of-the-court brief in support of the defendants' appeal.
Does Operating Agreement's Clause Permitting Competitive Activities Eliminate Member's Fiduciary Duty to Disclose Negotiations to Sell LLC's Assets Before Buying Out Co-Members?
The question posed by this post's title derives from an unpublished decision earlier this month in a case called Pappas v. Tzolis, Mem. Dec., Index No. 601115/09 (Sup Ct NY County Mar. 3, 2010). The case involves a real estate LLC whose operating agreement included a frequently used "Other Activities" clause expressly authorizing the members to engage in competitive business ventures. One member bought out the other two, allegedly while he was secretly negotiating with an unrelated outside buyer of the LLC's sole asset. The sale took place about six months after the member buyout for a price far in excess of what the former members received. The court dismissed the former members' complaint alleging that the failure to disclose the negotiations with the outside buyer breached fiduciary duty, holding that the Other Activities clause eliminated fiduciary duty.
Pappas raises several interesting questions, the first of which has two parts: (a) what law determines fiduciary obligations in a Delaware LLC whose operating agreement expressly provides that it is to be governed by New York substantive law, and (b) why would parties form a Delaware LLC but opt to apply New York law? Second, under either state's law, can the members completely eliminate a fiduciary duty of disclosure of the sort alleged in Pappas? Third, did the specific language of the operating agreement's clause permitting competition eliminate such duty? Complicated issues all, the answers to which could occupy a law review article.
According to the complaint in Pappas (read here), in January 2006 the two plaintiffs and defendant Steve Tzolis formed Vrahos LLC as a Delaware limited liability company to renovate and lease space in a Manhattan commercial building under a 49-year net lease acquired by the LLC. Tzolis owned a 40% interest and the plaintiffs held the other 60%. (Yes, trivia fans, this is the same Tzolis of Tzolis v. Wolff fame.)
Around March 2006, the parties finalized and executed an operating agreement (read here) that contemplated subleasing the building to Tzolis at a rent $4.00 per square foot in excess of the rent due the building's owner under the prime lease, such excess amounting to about $20,000 per month. Section 10 of the operating agreement designated all three members as managers of the LLC and required unanimity on all decisions and actions required or permitted to be taken by the managers. Section 11, entitled "Other Activities of Members," provided as follows:
Any Member may engage in business ventures and investments of any nature whatsoever, whether or not in competition with the LLC, without obligation of any kind to the LLC or to the other Members.
Section 12 of the operating agreement, entitled "Liability of the Members," provided that no member:
shall be liable to the LLC or to any other person or entity for any act or omission performed or omitted by such Member in good faith pursuant to the authority granted such Member or Manager by this Agreement, other than acts of fraud, bad faith or willful tortious misconduct.
Notwithstanding that the LLC was formed in Delaware, Section 15 of the operating agreement, entitled "Applicable Law," provided that "[t]his Agreement shall be governed and construed under the substantive laws of the State of New York."
Plaintiffs alleged that after taking over the building Tzolis failed to pay the additional sublease rent to the LLC and instead proposed a buyout of the plaintiffs' interests for the combined sum of $1.5 million, which they accepted in January 2007 after which Tzolis became the LLC's sole member. The buyout documentation included a "Certificate" executed by the plaintiffs stating that "each of the undersigned sellers agrees that Steve Tzolis has no fiduciary duty to the undersigned sellers in connection with [the sales of their interests]."
Plaintiffs further alleged that, prior to January 2007, Tzolis entered into secret discussions with the Extell Development Company to transfer the lease to an Extell affiliate for $17.5 million, which transfer took place in August 2007. The complaint asserts, among other claims, that Tzolis breached fiduciary duty and the implied contractual duty of good faith and fair dealing by failing to disclose the opportunity to sell the lease to Extell.
Tzolis moved to dismiss the complaint. In his memorandum of law (read here), he argued that because the LLC was formed in Delaware, that state's law governed the LLC's internal affairs and that under Delaware law, the parties were free to, and did in Section 11, eliminate any alleged fiduciary duty of disclosure to the plaintiffs surrounding Tzolis's dealings with Extell.
The plaintiffs' opposing memorandum of law (read here) contended that the court was obligated to respect the New York choice-of-law provision in Section 15 of the operating agreement; that New York law as pronounced in Blue Chip Emerald LLC v. Allied Partners, Inc., 299 AD2d 278 (1st Dept 2002), imposed upon Tzolis a duty to disclose his alleged negotiations with Extell; and that the Other Activities clause in Section 11 of the operating agreement did not constitute a waiver of fiduciary duty concerning transactions involving the subject LLC, but only as to outside business activities.
The decision written by Judicial Hearing Officer Ira Gammerman agreed with Tzolis and dismissed the complaint. Addressing initially the choice of law question, JHO Gammerman ruled that '[f]or purposes of deciding this motion, I need not decide which law to apply, because the result is the same, under both Delaware and New York law."
Next, as to plaintiffs' allegation that Tzolis fraudulently induced them to sign the Certificate waiving fiduciary duty in connection with the sale of their interests to Tzolis, JHO Gammerman noted that Tzolis was not relying on the Certificate as effecting a waiver. Rather, he wrote, Tzolis relied on the Certificate only to the extent of "evincing and certifying the absence of any such duties on his part" as a result of the pre-existing waiver set forth in Section 11 of the operating agreement.
Then comes the heart of the ruling, in which JHO Gammerman held that Section 11 "eliminates the fiduciary relationship that would, otherwise, be owed by the members to each other . . .." JHO Gammerman rejected plaintiffs' reliance on the Blue Chip Emerald case where the appeals court reinstated fiduciary breach and fraud claims by a member of a Delaware LLC that owned New York realty. That case likewise involved a buyout of one member by another, followed by a sale of the property at a price far above the valuation given to the selling member at the time of the buyout. The court there stressed that the buying member was a fiduciary "until the very moment the buy-out transaction closed" and therefore was obligated to disclose any information that could reasonably bear on the selling member's consideration of the buying member's offer including the latter's knowledge of an outside buyer's higher offer. JHO Gammerman found that, "by contrast, the parties [in Pappas] agreed [in Section 11] that, from the start of the LLC, they would have no fiduciary duty to it, or to each other."
JHO Gammerman also observed that § 18-1101(c) of the Delaware LLC Act explicitly authorizes elimination of fiduciary duties in the operating agreement, and that "[s]imilarly, under New York law, parties are free to contract as they wish, so long as the terms of their contract are neither unlawful, nor in violation of public policy." The decision does not mention the mandatory provision in § 409(a) of the New York LLC Law imposing on managers an obligation to "perform his or her duties as a manager . . . in good faith and with that degree of care that an ordinarily prudent person in a like position would use under similar circumstances."
The fiduciary duty implicated by Section 11 of the operating agreement in Pappas is one of loyalty, which is not expressly mentioned in § 409. What about the statute's reference to "good faith"? I'm not aware of any court ruling in the LLC context construing "good faith" as used in the statute. On the other hand, § 409's language is lifted verbatim from § 717(a) of the Business Corporation Law governing duties of corporate directors. In Foley v. D'Agostino, 21 AD2d 60 (1st Dept 1964), an intermediate appellate court interpreted "good faith" as used in the latter statute as meaning:
[Directors] may not assume and engage in the promotion of personal interests which are incompatible with the superior interests of their corporation. (See 19 C. J. S., Corporations, § 761, and cases cited.) "Officers and directors of a corporation owe it to their undivided and unqualified loyalty. * * * They should never be permitted to profit personally at the expense of the corporation. Nor must they allow their private interests to conflict with the corporate interests. These are elementary rules of equity and business morality. Courts of equity must ever enforce strict compliance with these rules."
So if good faith has the same meaning for purposes of § 409 as it does for § 717, inclusive of the duty of loyalty, does Section 11 in the Pappas agreement contravene the statute?
Assuming it doesn't, and that JHO Gammerman therefore also is correct in concluding that New York and Delaware law do not differ on the issue of permissive waiver, I come back to the question whether the specific language used in Section 11 eliminates the fiduciary duty that otherwise would exist. Such competition clauses are commonly found in agreements among co-owners of real estate companies where the individual owners may be involved in any number of other ventures on their own or with different business partners, some of which may be competing in the same market for tenants, services and finance. Do such provisions encompass self-dealing with respect to insider transactions involving the company's own assets, or do they only permit competitive activities involving outside business interests?
In Pappas, JHO Gammerman chose the former interpretation based on Section 11's broad reference to "business ventures and investments of any nature whatsoever" (emphasis added). He also cited this language in distinguishing Continental Ins. Co. v. Rutledge & Co., 750 A2d 1219 (Del. Ch. 2000), where the court ruled that alleged self-dealing within the partnership was not insulated by the partnership agreement's provision permitting partners to engage "in other business activities of every kind and description" (emphasis added). JHO Gammerman also was careful to note that, although Section 11 is entitled "Other Activities of Members" (emphasis added), Section 20.7 of the operating agreement stated that "[t]he headings in this Agreement . . . shall be given no effect in the interpretation of this Agreement."
Last year, in Bay Center Apartments Owner, LLC v. Emery Bay PKI, LLC, No. 3658-VCS (Del. Ch. Apr. 20, 2009), Vice Chancellor Leo Strine instructed that, absent contrary provision in the operating agreement, LLC members owe each other the traditional fiduciary duties owed by directors to a corporation, and that the intent to eliminate fiduciary duty in the operating agreement must be made "plain and unambiguous." Does Section 11 meet that test? Is it material that Section 11 speaks of no "obligation" without expressly referring to waiver of fiduciary duty? Is the duty to disclose recognized in Blue Chip Emerald coterminus with the duty not to compete eliminated by Section 11? We'll have to wait and see if the losing side in Pappas takes an appeal. In the meantime, anyone drafting such a provision in a partnership, shareholders or operating agreement would be well advised to include the words "other business activities" in the body of any provision permitting competition by the owners.
Ribstein on Pappas: Read here Professor Larry Ribstein's cogent analysis of Pappas.
Update April 25, 2010: Plaintiffs in Pappas filed a notice of appeal on April 1, 2010. We'll have to wait and see if they perfect their appeal.
Update September 19, 2011: The case has taken a radical turn in favor of the plaintiffs. Last week, the Appellate Division, First Department, reversed JHO Gammerman's decision and reinstated the fiduciary breach and fraud claims. Read here my post on the appellate decision.
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.
