Recent Appellate Rulings Clarify Standards for Challenging Releases Given to Fiduciaries of Closely Held Business Entities: Part 2
This is the second of two posts analyzing two recent decisions by the Manhattan-based Appellate Division, First Department, in which the court dismissed fraudulent inducement claims by LLC members against co-member fiduciaries arising from agreements that included broad general releases. Last week's post examined Centro Empresarial Cempresa S.A. v. America Movil S.A.B. de C.V., 2010 NY Slip Op 04719 (1st Dept June 3, 2010), which involved a dispute over a buyout between members of a Delaware LLC that owned an Ecuadorian mobile telephone company. The second case, discussed in this week's post, also concerns a dispute between co-members of a Delaware LLC, but this time the business operations are closer to home, involving a series of real estate acquisitions in New York City.
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The case of Arfa v. Zamir is one of those hydra-headed business partnership disputes that takes on a life of its own, generating multiple lawsuits and dozens of motions, decisions and appeals that take up years before anything seems to get resolved on the merits. I've written up decisions in the Arfa family of cases on several prior occasions, most recently on the issue whether LLC promoters are fiduciaries (see here), before that on indemnification rights of LLC managers (see here), and before that on whether a general release of a LLC fiduciary given as part of an inter-member transaction bars a subsequent action for fraudulent inducement (see here).
The last-mentioned post highlighted a December 2008 decision by Manhattan Commercial Division Justice Charles E. Ramos refusing to dismiss a fraudulent inducement claim by plaintiffs Rachel Arfa and her husband, Alexander Shpigel, as 60% members of the subject LLC, against defendant Gadi Zamir, who held the remaining 40% interest, relating to a real estate acquisition and development venture in upper Manhattan known as Academy Street. Here's a short summary of the factual background from my prior post:
The plaintiffs allege that in late 2004, Zamir recommended that the parties acquire Academy Street based on various income and expense projections, and that in reliance on Zamir's recommendation and presentations they approved the deal which closed in April 2005. Plaintiffs allege that in the summer of 2005, they learned of serious problems with the building's physical condition which allegedly were known to Zamir and withheld from plaintiffs at the time Zamir solicited their approval.
Meanwhile, plaintiffs and Zamir entered into a Governance Agreement dated June 9, 2005, which was intended to resolve growing frictions between them over management and control of the entire real estate portfolio. The plaintiffs allege that they "reluctantly agreed" to Zamir's "demand" that they enter into the Governance Agreement "to appease Zamir and prevent him from destroying the value of the real estate portfolio . . .." Mutual veto power over management decisions appears to be the main thrust of the Governance Agreement. The Governance Agreement also contains a mutual general release in which the parties release one another from "any and all claims . . . known or unknown" arising from events that pre-date the Governance Agreement.
Zamir moved to dismiss the plaintiffs' Fifth Cause of Action for fraudulent inducement, arguing that it was barred by the release contained in the Governance Agreement. Justice Ramos's December 2008 decision denied the motion, holding that under the First Department's decision in Littman v. Magee, 54 AD3d 14 (1st Dept 2008),
to the extent that Zamir owed Plaintiffs a fiduciary duty by virtue of being co-managers, he may not rely upon the Release to insulate himself from liability where he intentionally concealed from Plaintiffs the physical condition of the Academy Street Property, and which misrepresentation was an inducement to enter into the release from the outset.
Zamir appealed. On July 13, 2010, the First Department handed down its decision, reported at 2010 NY Slip Op 06070, reversing Justice Ramos's ruling and dismissing the fraudulent inducement claim. The court's unanimous decision was authored by Associate Justice David Friedman who also wrote the majority opinion in the First Department's 3-2 ruling in the Centro case discussed in last week's post.
Justice Friedman's Arfa opinion emphasizes factors closely tracking those found critical in Centro. He notes that the fraudulent inducement claim:
- "falls squarely within the scope of the general release";
- that the Governance Agreement "was the result of rigorous, arm's-length negotiations between the highly sophisticated parties";
- that "by the time the parties began negotiating the Governance Agreement, they had already developed an adversarial, even hostile relationship";
- that given the plaintiffs' own allegations of Zamir's dishonesty, they had a "heightened" affirmative duty to protect themselves from misrepresentations by investigating all of the circumstances and details surrounding the Governance Agreement;
- that had the plaintiffs performed the requisite due diligence, the matters concerning the Academy Street Building's physical condition, about which Zamir allegedly made misrepresentations, "presumably would have been revealed"; and
- that the plaintiffs could not establish reasonable reliance on Zamir's alleged misrepresentations when they failed to make "any use of the means available to them to ascertain the truth of the alleged misrepresentations at issue before they entered into the Governance Agreement."
Justice Friedman, quoting from his Centro opinion, also rejects what he calls the "implication" of the plaintiffs' position, i.e., that "a fiduciary can never obtain a valid release without first making a full confession of its sins to the releasor," and then goes on to distinguish Littman v. Magee, writing:
In Littman, a general release in the agreement for the sale of the plaintiff's interest in a closely-held business was held not to bar a fraud action against a former fiduciary at the pleading stage because the complaint was deemed to allege that the defendant fiduciary had told the plaintiff that no further documentation bearing on the valuation of the enterprise existed. While Littman reaffirmed that even a fraud claim against a fiduciary must establish justifiable reliance on the alleged misstatement, the case held that the alleged misrepresentation concerning the availability of information relevant to the transaction raised an issue as to whether plaintiff justifiably relied on the defendant's statements without making further investigative efforts (54 AD3d at 19). Here, by contrast, Arfa/Shpigel do not allege that Zamir did or said anything to impede their ability to investigate the truth and completeness of his representations concerning the Academy Street building. On the contrary, assuming the truth of the complaint, Arfa/Shpigel never asked Zamir for even a page of documentation of the condition of the building.
So there you have it. Two First Department decisions, Centro and Arfa, both of which limit Littman to its specific facts and implicitly reject Littman's broader pronouncements suggesting that a release given to a fiduciary does not protect against a nondisclosure-based, fraudulent inducement claim. As noted last week, the Centro plaintiffs filed a notice of appeal as of right to the Court of Appeals, which will have the last word, so stay tuned.
Recent Appellate Rulings Clarify Standards for Challenging Releases Given to Fiduciaries of Closely Held Business Entities: Part 1
Two years ago, in Littman v. Magee, 54 AD3d 14 (1st Dept 2008), the Manhattan-based Appellate Division, First Department, made waves with a decision in which it reinstated a complaint for breach of fiduciary duty and fraudulent inducement by an LLC member who sold his minority interest to the majority, gave them a comprehensive release and, over a year later, after the majority sold the company at a substantial premium, claimed he had been misled as to the true value of his interest. My write-up of the decision (read here) referred to Littman as "lowering the bar" for claims of this sort by making broad pronouncements that seemingly elevated beyond the power of release the purchaser-fiduciary's duty to disclose to the seller all material facts bearing on the transaction. At the time, with some degree of concern, I posed the question, "After Littman, can business owners pursue and exploit the profitable sale of their business or its assets without risk of liability to a former partner whose interest was acquired at a cheaper price?"
In a recent pair of decisions, the First Department effectively has enervated Littman's broad pronouncements regarding the inefficacy of releases vis-à-vis the fiduciary duty of disclosure. In Centro Empresarial Cempresa S.A. v. America Movil S.A.B. de C.V., 2010 NY Slip Op 04719 (1st Dept June 3, 2010) (hereafter "Centro"), and Arfa v. Zamir, 2010 NY Slip Op 06070 (1st Dept July 13, 2010) (hereafter "Arfa"), lower courts had denied motions to dismiss fraudulent inducement claims by LLC members who entered into transactions which included an exchange of general releases. In both cases, the plaintiffs argued, and the lower courts agreed, that under Littman a general release does not insulate a fiduciary from liability for failing to disclose the fiduciary's own wrongdoing. On appeal in both cases, the First Department reversed the lower courts' orders and directed dismissal of the claims, finding that the plaintiffs had failed to allege facts sufficient to set aside their releases. In both cases, the First Department expressly distinguished Littman by limiting it to its particular facts.
Interestingly, both appellate decisions were authored by Associate Justice David Friedman who was not on the panel that decided Littman as were none of the other Arfa panel members and only one of the Centro panel members. As related below, the one Centro panel member who also decided Littman -- Associate Justice Catterson -- was half of a two-judge dissent in Centro.
In this Part One of a two-part series, I report on the Centro decision. In next week's Part Two, I'll report on the Arfa decision.
The Centro Decision
Centro involved a dispute between minority and majority members of a Delaware LLC that owned an Ecuadorian mobile telephone company known as Conecel. In March 2000, the majority member Telmex (controlled by Mexican billionaire Carlos Slim) acquired a 60% interest in Conecel. Telmex simultaneously entered into two agreements with the plaintiff minority members. The first stipulated that, in the event Telmex rolled up its Latin American telecommunications interests into one entity for the purpose of an equity offering, the plaintiffs would have the right to exchange their interest in Conecel for an interest in the new entity (the "Roll-Up Agreement"). The second agreement gave plaintiffs the right to put their Conecel interests to Telmex at specified intervals spread over 6 1/2 years at a fixed price based on Conecel's 1999 valuation (the "Put Agreement").
The plaintiffs alleged that Telmex's formation in late 2000 of a new company known as America Movil triggered their right of exchange under the Roll-Up Agreement. They further alleged that over the next year Telmex dodged most of their requests for financial information necessary to determine the exchange rate, and that the information they did extract painted a false, bleak picture of the company's finances.
Having been led to believe that Conecel was in financial difficulty, in March 2002 the plaintiffs exercised their first put right under the Put Agreement by selling 50% of their membership interests to Telmex for $64 million. After another year of alleged obfuscation and misrepresentation by Telmex of Conecel's financial condition, in March 2003 Telmex offered to purchase the plaintiffs' remaining 50% interest ahead of the Put Agreement's schedule at the same floor price of $64 million. In July 2003, Telmex and the plaintiffs entered into a Purchase Agreement for the remaining 50% which also included a broad general release in Telmex's favor of all claims relating to the plaintiffs' membership interests in Conecel.
Plaintiffs' complaint alleged that, years after the buy-out of their interest, Telmex's alleged dishonesty was exposed as a result of an audit of Conecel by the Ecuadorian tax authority which allegedly revealed that Conecel's true financial results in 2001-03 were considerably better than represented by Telmex when it offered to purchase plaintiffs' interests. Plaintiffs claimed that, had Telmex honored their right to negotiate an exchange of their Conecel units for America Movil shares, plaintiffs would have owned America Movil shares worth more than $1 billion as of May 30, 2008 (the date of the complaint).
The lower court, in an unreported December 2008 decision dictated on the record by Justice Richard B. Lowe III, denied Telmex's dismissal motion in which Telmex contended that the general release given by plaintiffs barred their claim. Telmex appealed.
Over a vigorous two-judge dissent, a three-judge majority reversed the lower court's order and dismissed the complaint. The self-responsibility theme of Justice Friedman's majority opinion is struck early, in his description of the facts, when he notes that
It is undisputed that the Purchase Agreement [including the general release] was the product of rigorous, arm's length negotiations between sophisticated parties, all of whom were advised by their own expert legal counsel.
The legal analysis portion of Justice Friedman's opinion initially establishes that the plaintiffs' fraudulent inducement claim falls squarely within the scope of the broad release given in the Purchase Agreement, and that "[w]hether or not plaintiffs had reason to suspect that defendants were misrepresenting the value of Conecel in the negotiation of the 2003 transaction, they cannot reasonably contend that they did not intend to release possible fraud claims as to that matter of which they were unaware."
Justice Friedman then strongly rejects the central premise of plaintiffs' Littman argument, keyed to Telmex's fiduciary status as the controlling member of Conecel, writing as follows:
While Telmex LLC, as the holder of the majority interest in TWE (and, through TWE, Conecel) owed plaintiffs certain fiduciary duties, the foregoing principles apply (at least among sophisticated parties advised by counsel) even where the releasee is a fiduciary. If Telmex LLC's fiduciary status alone sufficed to prevent it from obtaining the dismissal of this action based on the 2003 release, the implication would be that a fiduciary can never obtain a valid release without first making a full confession of its sins to the releasor, regardless of the releasor's sophistication and the arm's length nature of the negotiations from which the release emerged. This is not the law. Such a rule would render useless and meaningless any release of a party that owed the releasor a fiduciary duty, thereby unjustifiably impinging on the freedom of commercial actors to order their own affairs by contract and, moreover, contravening the public policy favoring the settlement of business disputes. We are not aware of any precedent compelling us to accept such an absurd result. [Citations omitted.]
The plaintiffs, Justice Friedman continues, "entered into the 2003 transaction well aware that defendants had not given them access to the internal financial records of Conecel" and "should have insisted on access to Conecel's internal books and records" and, moreover, should have sued if necessary to obtain the information. He also notes that during the period in question, "relations between the parties were adversarial, if not outright hostile, thereby negating as a matter of law any inference that business entities as sophisticated as plaintiffs were relying on defendants for an objective assessment of the value of their investment."
Justice Friedman distinguishes Littman in a footnote. He does not confront Littman's broad pronouncements, but instead focuses on the specific factual allegations in that case, writing as follows:
[In Littman], a general release in the agreement for the sale of the plaintiff's interest in a closely-held business was held not to bar a fraud action against a former fiduciary at the pleading stage because the complaint was deemed to allege that the defendant fiduciary had told the plaintiff that no further documentation bearing on the valuation of the enterprise existed, thereby exonerating the plaintiff from the need to investigate further (54 AD3d at 19). Here, plaintiffs do not allege that defendants told them that no information about Conecel's financial condition beyond the minimal amount that had been shared with plaintiffs was in existence. In addition, the Littman plaintiff alleged that he was induced to sell out in part by a "threat[] that if [he] did not agree to the proposed sale, approximately $1 million in income would be allocated to him for the year 2004, while no distribution would be made to him to cover the taxes resulting from that allocation" (id. at 16). No such threat or duress is alleged here.
Justice Friedman's opinion also distinguishes Littman's doctrinal forebear, Blue Chip Emerald v. Allied Partners, 299 AD2d 278 (1st Dept 2002), where the First Department upheld a fraudulent inducement claim involving a buy-out of a minority partner who alleged that the majority kept secret a third-party offer for the company's sole asset at a substantially higher price. Here's what he says about Blue Chip:
It was critical to the result in Blue Chip that the plaintiff in that case did not have "at its disposal ready and efficient means" for ascertaining whether such an oral agreement (or an offer in the relevant price range) even existed (299 AD2d at 280). Here, by contrast, plaintiffs were well aware that Conecel did have a value, and nonetheless chose to cash out their interests without either insisting on verifying defendants' representations as to that value or, on the other hand, conditioning the deal on the accuracy of the information they did receive. Indeed, as previously discussed, plaintiffs here were well aware that they were not in possession of all the information they believed they were entitled to when they sold their interests.
In a lengthy dissent, Associate Justice James M. Catterson sharply takes the majority to task for "overlook[ing] the well-established precept that releases 'must be knowingly and voluntarily entered into', and propound[ing], instead, the view that an effective release is one in which the releasor is hoodwinked by the releasee" (citations omitted). Citing Littman, Justice Catterson writes that a general release "will not insulate a tortfeasor from allegations of breach of fiduciary duty, where it has not fully disclosed alleged wrongdoing," and therefore the plaintiffs in Centro
were reasonably justified in their expectations that the defendants would disclose any information in their possession that might affect plaintiffs' decision on their best course of action especially as to signing the release that the defendants now argue bars this action.
Justice Catterson also disagrees with what he calls "the majority's attempt to distinguish Littman," writing that
The majority does so on the basis that the plaintiff in Littman was told that no further documentation bearing on the valuation of the enterprise existed, thus exonerating him from the need to investigate further whereas here the plaintiffs were not so told. I fail to see how being told that no documentation exists provides a better basis for exoneration than receipt of publicly filed documents. In the instant case, whatever message was being conveyed by the defendants' stonewalling, it was not incumbent on the plaintiffs to suspect that the defendants were defrauding a governmental agency by publicly filing false information.
On June 21, 2010, the plaintiffs in Centro filed a notice of appeal to the New York Court of Appeals which they are allowed to do as of right because of the two-judge dissent. It will be most interesting and important to see how the state's highest tribunal resolves the clash of judicial philosophies evident in the dueling opinions of the Centro majority and dissenters.
Court Invalidates Control-Shifting Stock Transfer Made in Violation of Corporation's Right of First Refusal
The right of first refusal (RFR) is a type of stock transfer restriction found in shareholder agreements of closely held corporations. Under the most common form of RFR, the shareholder seeking to transfer his or her shares to another person is required to submit sequentially to the corporation and, if the corporation declines, to the other shareholders the opportunity to purchase the shares on the same terms as are being offered by the proposed purchaser. The courts routinely enforce RFRs in recognition of the special partnership-like character of close corporations.
A recent decision by the Appellate Division, First Department, in Giaimo v. EGA Associates Inc., 2009 NY Slip Op 09277 (1st Dept Dec. 15, 2009), illustrates the mischief that can occur when the RFR is not properly spelled out in a shareholders' agreement but, instead, is set forth in abbreviated and incomplete form on the back of the share certificates. Giaimo also illustrates the paramount importance New York courts place on the fiduciary duties owed by majority shareholders and directors of close corporations to minority shareholders, arguably to the point of preempting the statutory scheme governing director's self-interested transactions.
EGA Associates Inc. (EGA) is a closely held New York corporation formed in 1961 to own and operate real estate. According to the complaint filed by Robert Giaimo (read here), the stock of EGA was held one-third each by Robert and his siblings, Edward and Janet. Edward died after a long illness in March 2007. Edward's will bequeathed his EGA shares in equal parts to Robert and Janet, which would have left them as equal 50% shareholders. Two weeks before his death, however, Edward sold one of his shares to Janet for $80,000, thereby giving her majority ownership upon Edward's death. Some months later, Janet gave notice of meetings of the shareholders and directors at which she obtained voting control of the board by electing herself and her lawyer as two of the three directors.
Robert's lawsuit sought declaratory and injunctive relief setting aside the sale of stock by Edward to Janet on the ground it violated the crude RFR printed on the back of the stock certificates issued to each of the three siblings, providing as follows:
Shares are not transferable without granting the corporation thirty (30) days written notice of sale of terms, involved parties and a first option to purchase said shares before transfer to other existing shareholders or to third parties, except in the case of transfers to immediate family (spouse and children only). Such restrictions shall not apply [sic]. Corporate first option preserved for all subsequent transfers.
Janet defended the stock sale by alleging that, before he died, Edward told her that, in his capacity as EGA's president, he had waived EGA's right of first refusal prior to the sale, although apparently the waiver was never separately documented. Janet also contended that Edward believed that Robert would sell his shares in EGA, and that he decided to sell one of his shares to Janet to ensure that EGA remained within the family and to prevent shareholder gridlock.
Robert moved for summary judgment canceling the sale and voiding the actions taken at the subsequent shareholder and director meetings. He argued that Janet's testimony relating Edward's statement concerning the company's waiver of the RFR was barred by the Dead Person's Statute, codified in Section 4519 of the Civil Practice Law and Rules. Robert alternatively argued that the sale was invalid under Section 713(a) of the Business Corporation Law which authorizes interested-director transactions upon appropriate disclosure and approval vis-a-vis disinterested directors and/or shareholders.
The trial court, in a decision by New York County Supreme Court Justice Marcy S. Friedman reported at 2008 NY Slip Op 32944(U) (Sup Ct NY County Oct. 28, 2008), denied Robert's motion. First, she ruled that the Dead Person's Statute did not bar Janet's testimony concerning her discussions with Edward at the pre-trial phase where there is other admissible, corroborating evidence including a bill of sale for the stock and a new stock certificate, both authenticated by Edward's personal assistant. Second, Justice Friedman ruled that Robert had not eliminated triable issues as to whether, as EGA's president, Edward had authority to waive the RFR without board approval. Third, she ruled that even if BCL Section 713 applied, Robert failed to eliminate triable issues as to whether the stock sale to Janet was fair and reasonable to EGA under subsection (b) of the statute, which would allow an interested-director transaction that otherwise fails to comply with the disclosure and approval requirements. As to the last point, the court cited Janet's contention that Edward's alleged desire to prevent shareholder gridlock constituted a "bona fide purpose" for the stock sale. Justice Friedman also cited testimony by EGA's accountant who suggested that the $80,000 paid by Janet over-valued the share of stock, at least compared to its book value.
Robert appealed the trial court's decision to the Appellate Division, First Department, which unanimously reversed the decision and entered summary judgment in Robert's favor voiding the stock sale and the subsequent actions taken at shareholder and directors meetings. The court's short decision expressly rejects Janet's argument based on Edward's alleged waiver of the RFR, holding that "[a]s the president of a closely held corporation, Edward lacked the power to act unilaterally against Robert's interest" and citing several precedents in which courts recognize the fiduciary duties owed by majority shareholders to the minority in closed corporations. The decision also rejects Janet's argument that the transfer restrictions on the stock certificates were invalid in the absence of other "corporate documents evidencing their approval," adding that "the three shareholders accepted these restrictions without objection and relied on them until after this litigation was commenced."
Notably absent from the appellate decision is any mention of Janet's argument, accepted by the trial court, that the company's alleged waiver of the RFR in an interested-director transaction, notwithstanding non-compliance with the disclosure and approval requirements of BCL 713(a), might be sustainable under BCL 713(b) as "fair and reasonable as to the corporation." I can think of at least two possible reasons for the omission. First, the stock sale apparently was never formally submitted to the board or the shareholders for a vote, so it's not clear by its terms that BCL 713(b) applies. Second, the waiver dispute in this case is linked inextricably to the predominant question of shareholder control of a closely held corporation, i.e., it is not primarily a question of what's fair and reasonable to the corporation which generally has no independent, cognizable interest in deciding who holds the reins of management. This second reason opens the door wide to the appellate court's elevation of fiduciary duty owed to minority shareholders as the deciding principle.
As mentioned above, a fully developed RFR provision in a shareholders' agreement likely would have avoided this dispute. Among other things, it would have required that the share be offered to the other shareholders in the event the company opted not to acquire the share. Such a provision would have enabled Robert to maintain his 50% interest.
One final footnote. In July 2007, Robert filed a separate petition to dissolve EGA pursuant to the deadlock dissolution statute BCL 1104, as well as under the oppressed minority shareholder statute BCL 1104-a (read petition here). Janet thereafter elected to purchase the petitioner's shares in lieu of dissolution. It appears that a valuation hearing was conducted in 2009, before the appellate ruling discussed above, but that there's been no valuation decision much less a consummation of the buyout. It will be interesting to see whether and how the appellate court's invalidation of the stock sale to Janet will affect the pending dissolution/buyout proceeding.
