Member of Real Estate LLC Never Withdrew, Held Entitled to Share of Sale Proceeds
Inadequate and erroneous documentation of ownership is an all too common feature of closely held businesses and, after disputes arise, a wellspring for litigation over an aggrieved business partner's standing to assert financial claims or to seek judicial dissolution.
The reasons for this state of affairs are many and diverse, e.g.: The owners lack a sophisticated understanding of the legal formalities attendant to ownership of the chosen form of business entity. The owners are unable or unwilling to spend the money for proper legal and accounting services. The owners are family members or long-time friends who trust one another and believe they don't need any written agreement or certification of ownership interests.
When litigation erupts and the complaining party's ownership interest is challenged, in the usual case the issue is whether the complaining party ever became a shareholder or, if the case involves a limited liability company, ever held a membership interest. This type of dispute has been the subject of more posts on this blog than almost any other single subject. (Click on the topic "Standing" on the right sidebar and you'll see what I mean.)
A decision last month by Nassau County Commercial Division Justice Stephen A. Bucaria in Gitlin v. Chirinkin, Short Form Order, Index No. 012131/07 (Sup Ct Nassau County June 29, 2011), presents a twist on the usual fact pattern. In Gitlin, no one contested that the plaintiff became a 50% member of the subject LLC at its inception. Rather, the issue was whether the plaintiff's membership interest subsequently terminated, as the other 50% member contended, such that the plaintiff had no entitlement to share in the profits of transactions that took place after his alleged termination.
Background
Plaintiff Eduard Gitlin and defendant Alex Chirinkin were close friends and business associates in March 1997 when they formed Kew Apartment Holdings, LLC ("Kew") to buy and sell New York City co-op apartments. Gitlin, a licensed real estate broker, oversaw the investments, the last of which was sold in 2001. Gitlin's lawsuit did not make any claims regarding those investments.
Rather, the claims involve two Nevada real properties acquired in 1998 known as the Pahrump and Lucky Bucks properties. The Pahrump property was purchased for about $1.14 million, owned 20% by Kew and 80% by another LLC wholly owned by Chirinkin. Neither Gitlin nor Kew contributed any cash toward the purchase price, although Gitlin did co-sign with Chirinkin on Kew's behalf an installment note and escrow agreement. In 2003, Chirinkin, acting alone and without Gitlin's knowledge, conveyed title for no consideration to another LLC wholly owned by Chirinkin (75%) and to an individual named Arkady Pavlov (25%) who paid Chirinkin (or one of his companies) $230,000. In 2005, following an interim conveyance to yet another Chirinkin-controlled company, the Pahrump property was sold to a third-party buyer for $15.8 million.
The Lucky Bucks property was purchased for about $530,000 with title held jointly by Kew (50%) and two outside investors, one of whom was later replaced by Pavlov. In 2002, the Lucky Bucks property was sold to the U.S. government for about $1.63 million. At the time Gitlin had no knowledge of the Lucky Bucks acquisition or its subsequent sale.
None of the sale proceeds from the Pahrump or Lucky Bucks transactions was paid to Kew.
A Lengthy Litigation
In 2007, after learning about the Pahrump deal, Gitlin sued Chirinkin, Chirinkin's wife, Pavlov and two of Chirinkin's other companies for various claims brought individually and derivatively on Kew's behalf, including conversion, fraud, unjust enrichment, fiduciary breach and fraudulent conveyance. In a decision dated November 21, 2007 (read here), Justice Bucaria dismissed all the derivative claims -- this was before the Court of Appeals in the Tzoliz case recognized common law derivative claims by LLC members -- and several other claims either as time barred or insufficiently pleaded.
In an October 2008 decision (read here), Justice Bucaria reinstated Gitlin's derivative claims (this followed the February 2008 Tzoliz decision) and granted leave to add claims relating to the Lucky Bucks transaction which Gitlin apparently first learned about in discovery. In March 2009, the Appellate Division, Second Department, denied Chirinkin's appeal from this decision (read here).
In a July 2009 decision (read here), which also was affirmed on appeal in March 2010 (read here), Justice Bucaria denied a defense motion to compel Gitlin to produce his personal tax returns and bank statements which, Chirinkin argued, he needed to prove that Gitlin no longer had a membership interest in Kew when the Pahrump and Lucky Bucks properties were sold. Justice Bucaria's decision notes that Section 9.1 of Kew's operating agreement dated March 1997, which lists Gitlin as a 50% member, "requires some affirmative action to accomplish the withdrawal of a member and that must be accomplished 'either in writing or at a meeting called for such purpose.'" According to Justice Bucaria, defendants' failure to produce evidence of such an event creates "a clear presumption that such membership continues" thus rendering immaterial "defendants' demand for documentation to prove the negative."
The Summary Judgment Arguments
In March 2011, Gitlin moved for summary judgment seeking recovery of all of the sale proceeds from the Pahrump and Lucky Bucks transactions. Gitlin's memorandum of law (read here) argued that Chirinkin's sale of the properties violated Section 402(d)(2) of the LLC Law and Section 5.5 of Kew's Operating Agreement requiring the consent of two-thirds in interest of the members; that Chirinkin's transfers of title out of Kew for no consideration breached his fiduciary duty as manager under Section 409 of the LLC Law; and that the transfers also constituted unjust enrichment and fraud under common law and the provisions of the Debtor and Creditor Law.
Chirinkin's opposition brief (read here) argued against summary judgment based on questions of fact surrounding the status of Gitlin's membership in Kew when the properties were sold. Chirinkin contended that Gitlin contributed no funds to acquire or maintain the properties; that Gitlin spent no time managing the properties; that Chirinkin acquired the two properties by partially placing them in the name of Kew solely "for accounting purposes"; that Kew's tax returns for the years 1998 through 2001 did not show Gitlin as a member of Kew; that Kew's former accountant swore that Gitlin was not a member of Kew; and that the Operating Agreement produced by Gitlin during the litigation, which Gitlin originally denied existed, was bogus. Chirinkin also argued that because Kew initially held only a 20% interest in the Pahrump property, the 80% member (Chirinkin's other company) had an unrestricted right to transfer it to a third party. Chirinkin also argued that Gitlin commenced the lawsuit in an attempt to avoid repaying a $430,000 loan made by Chirinkin to Gitlin in 2006.
In his reply (read here), Gitlin argued that the 1998-2001 tax returns omitting Gitlin's membership should not be considered based on Chirinkin's deposition testimony in which he "would not confirm that they were true and accurate copies of the tax returns." Gitlin also cited Chirinkin's testimony that he alone provided the company's accountant with the information contained in its tax returns. Gitlin further argued that the Court's July 2009 discovery ruling, in which it denied production of Gitlin's tax returns based on the absence of evidence that he withdrew from the LLC, constituted the law of the case and was dispositive of Gitlin's member status.
The Court's Ruling
Justice Bucaria's legal analysis of Gitlin's member status initially quotes from the court's July 2009 decision but neither accepts nor rejects Gitlin's argument based on the law of the case. Rather, Justice Bucaria finds that, "even without that prior decision, the submitted evidence on this motion clearly establishes that Gitlin was a member of Kew with a 50 percent interest." Such evidence includes:
- Kew's Articles of Organization
- Kew's Operating Agreement
- the $696,050 Installment Note for the Pahrump acquisition co-signed by Gitlin
- the Escrow Agreement for the Pahrump down payment co-signed by Gitlin
As in his prior discovery ruling, Justice Bucaria finds, in what appears to be the most critical aspect of his ruling on this point, that Chirinkin
has failed to come forth with any evidence that an event of withdrawal occurred as required pursuant to Article IX, section 9.1 [of Kew's Operating Agreement].
Based on these findings Justice Bucaria grants summary judgment of liability against Chirinkin for breach of Section 5.5 of the Operating Agreement, breach of fiduciary duty under LLC Law Section 409, common law fraud for misrepresentations and omissions concerning the two properties, unjust enrichment, and fraudulent conveyance for transferring the properties for no consideration with actual intent to defraud Gitlin under Sections 273 and 276 of the Debtor and Creditor Law.
Justice Bucaria stops short of awarding damages and instead orders a trial, finding that
Chirinkin has raised an issue of fact as to the profit which Kew made upon the sale of the Nevada properties . . . [and] as to the damages which Gitlin suffered based upon the loss of his 50 percent share of the net profits realized by Kew upon the sale of the properties. . . . Accordingly a trial is necessary to determine the issue of damages.
I end as I began, with the observation that, for any number of reasons, a significant portion of the population of business owners always will conduct their affairs, record their business transactions, and report those transactions to tax authorities in ways that ignore or contradict the formalities and obligations imposed by the statutes that govern the chosen entity form and by the parties' shareholders agreement, by-laws or operating agreement. Sometimes the motives are innocent, sometimes not, but either way, the risks are very real and, as in Gitlin, can turn out to be very costly.
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.
