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.
New York's Top Court Resets the Bargaining Table When Controlling Owner of Closely Held Company Buys Out Minority Partner
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In the clash between the "punctilio of an honor the most sensitive" and the "morals of the marketplace" (Benjamin Cardozo in Meinhard v. Salmon), marketplace beat out punctilio.
That's one way to think about last week's important rulings by New York's highest appellate court in two cases testing the efficacy of releases as a defense against fraudulent inducement claims in litigation between co-owners and fiduciaries of closely held businesses. Another way to think about it: New York judges will not substitute their ex post judgment based on fluid notions of equity and fairness for contractual undertakings freely arrived at through arm's-length bargaining between sophisticated business partners.
In Centro Empresarial Cempresa S.A. v. America Movil, S.A.B. de C.V., 2011 NY Slip Op 04720 (Ct. App. June 7, 2011), the Court of Appeals affirmed the intermediate appellate court's dismissal of a lawsuit by minority owners of a privately-held telecommunications company, in which they alleged breach of fiduciary duty and fraud by the majority owner in connection with the buy-out of their equity interests, based on a written release given as part of the buy-out agreement. In Arfa v. Zamir, 2011 NY Slip Op 04719 (Ct. App. June 7, 2011), the Court of Appeals likewise held that a release provision in a co-management agreement between co-owners of a realty company required dismissal of breach of fiduciary duty and fraud claims based on alleged non-disclosure of major problems with a property acquisition.
In both cases, the trial courts had permitted the lawsuits to go forward citing case law from the Manhattan-based Appellate Division, First Department, seemingly indicating that a fiduciary involved in a self-interested transaction with another owner can almost never rely on a release to avoid liability against allegations of non-disclosure and fraudulent inducement. That broad proposition is dead after Centro and Arfa.
Centro, the more important of the two decisions, involves a Delaware LLC that owned an Ecuadorian telecommunications company known as Conecel. A company called Telmex, owned by Mexican billionaire Carlos Slim, held a 60% controlling interest in Conecel. In 2000, the plaintiffs, who held the other 40%, entered into various agreements with Telmex, among other things, giving plaintiffs the right to put their stake to Telmex at a fixed price based on a 1999 valuation.
Plaintiffs alleged that Telmex subsequently dodged their requests for financial information and otherwise falsely painted a bleak picture of Conecel's finances, causing plaintiffs in 2002 to exercise put rights for half their stake for $64 million. In 2003, after Telmex allegedly continued to obfuscate and provide misleading financial disclosure, Telmex offered to purchase plaintiffs' remaining stake for another $64 million. Plaintiffs accepted. The 2003 purchase agreement included a broad general release in Telmex's favor of all claims relating to plaintiffs' membership interests in Conecel.
In 2008, after a government audit allegedly disclosed that Conecel's financial condition in 2001-03 was significantly better than represented by Telmex, the plaintiffs sued Mr. Slim and his companies for breach of fiduciary duty and fraudulent inducement, claiming that had they known Conecel's true condition, instead of selling their shares they would have exercised certain exchange rights that would have given them shares in a roll-up entity worth over $1 billion in 2008.
The trial court denied defendants' motion to dismiss the suit based on the general release. Defendants appealed to the Appellate Division, First Department which, by 3-2 vote in a June 2010 decision, reversed the lower court and dismissed the complaint. (Read here my post about the First Department's ruling.) Plaintiffs then appealed to the New York Court of Appeals.
Following oral argument last April (watch it here), the Court of Appeals last week unanimously affirmed the First Department majority's ruling. In a unanimous decision written by Judge Carmen Ciparick, the court starts its analysis by stating the general rule, that a valid release constitutes a complete bar to an action on a claim which is the subject of the release, and that "a party that releases a fraud claim may later challenge that release as fraudulently induced only if it can identify a separate fraud from the subject of the release." The alleged fraudulent conduct in Centro, the court finds,
falls squarely within the scope of the release: plaintiffs allege that defendants supplied them with false financial information regarding the value of [Conecel] and that, based on this false information, plaintiffs sold their interests in [Conecel] and released defendants from claims in connection with that sale. Thus, as the Appellate Division observed: "plaintiffs seek to convert the 2003 release into a starting point for new . . . litigation, essentially asking to be relieved of the release on the ground that they did not realize the true value of the claims they were giving up."
The court then addresses the core issue: does the defendants' status as a fiduciary, standing alone, change the equation? Prior decisions of the First Department, exemplified most famously by Littman v. Magee, 54 AD3d 14 (2008), and Blue Chip Emerald v. Allied Partners, Inc., 299 AD2d 278 (2002), strongly suggested a "yes" answer, seemingly holding that the controlling owner involved in a transaction with another owner owes a non-releaseable fiduciary duty to disclose to the co-owner all material information bearing on the transaction. (Read here my post on Littman.) The Court of Appeals gives a definitive "no" answer, albeit with certain caveats, and in so doing explicitly disagrees with Littman et al. States the court:
A sophisticated principal is able to release its fiduciary from claims — at least where, as here, the fiduciary relationship is no longer one of unquestioning trust — so long as the principal understands that the fiduciary is acting in its own interest and the release is knowingly entered into (see Alleghany Corp., 333 F2d at 333 ["There is no prerequisite to the settlement of a fraud case that the (fiduciary) defendant must come forward and confess to all his wrongful acts in connection with the subject matter"]; Consorcio Prodipe, S.A. de C.V., 544 F Supp 2d at 191). To the extent that Appellate Division decisions such as Littman v Magee (54 AD3d 14, 17 [1st Dept 2008], Blue Chip Emerald v Allied Partners Inc. (299 AD2d 278, 279-280 [1st Dept 2002]), and Collections v Kolber, 256 AD2d 240, 241 [1st Dept 1998]) suggest otherwise, they misapprehend our case law. Plaintiffs here are large corporations engaged in complex transactions in which they were advised by counsel. As sophisticated entities, they negotiated and executed an extraordinarily broad release with their eyes wide open. They cannot now invalidate that release by claiming ignorance of the depth of their fiduciary's misconduct.
The court also emphasizes the plaintiffs' failure adequately to allege justifiable reliance on the defendants' fraudulent statements in executing the release:
Here, according to the facts alleged in the complaint, plaintiffs knew that defendants had not supplied them with the financial information necessary to properly value [Conecel], and that they were entitled to that information. Yet they chose to cash out their interests and release defendants from fraud claims without demanding either access to the information or assurances as to its accuracy in the form of representations and warranties. . ..
In certain circumstances, a fiduciary's disclosure obligations might effectively operate like a written representation that no material facts are undisclosed, and this might satisfy a principal's obligation to investigate further. Where a principal and fiduciary are sophisticated parties engaged in negotiations to terminate their relationship, however, the principal cannot blindly trust the fiduciary's assertions. This is particularly true where, as alleged here, the principal has actual knowledge that its fiduciary is not being entirely forthright . . ..
Plaintiffs repeatedly and unsuccessfully attempted to hold defendants to their disclosure obligations for years before negotiating and executing the sale of their shares and the accompanying releases. Moreover, the complaint alleges that plaintiffs were driven to sell because they were "wary of the threat that defendants would never negotiate in good faith and would never distribute the Conecel profits." Plaintiffs therefore cannot be said to have reasonably relied on defendants' assertions regarding Conecel's performance in executing the releases.
The 2003 release, the court concludes, "was intended to bar the very claims that plaintiffs now bring." The plaintiffs, who released defendants "without conducting even minimal dilgence to determine the true value of what they were selling," also "fail to allege that the release was induced by fraud beyond that contemplated by the release."
I won't linger on the court's brief, unsigned opinion in Arfa v. Zamir in which the plaintiffs sued a co-member of a realty holding company for fraudulent inducement concerning an agreement that gave the defendant co-equal management authority, notwithstanding the agreement's inclusion of a broad general release. The court affirms the First Department's decision enforcing the release and dismissing the case, finding that the plaintiffs failed to allege that the release was induced by a separate fraud or that plaintiffs justifiably relied on defendant's fraudulent misstatements in executing the release. In addition,
[b]y their own admission, plaintiffs, who are sophisticated parties, had ample indication prior to June 2005 that defendant was not trustworthy, yet they elected to release him from the very claims they now bring without investigating the extent of his alleged misconduct.
(For more background on Arfa and the lower courts' decisions, read here my prior post and watch here the oral argument before the Court of Appeals.)
In my post three years ago I queried whether, after Littman, "business owners [can] 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." With its explicit repudiation of the analysis used in Littman, the Court of Appeals in Centro and Arfa has reinvigorated the purpose and efficacy of negotiated releases in buy-outs and other agreements between co-owners/fiduciaries of closely held companies. The onus rests on the selling party to perform adequate diligence prior to completing the transaction, or otherwise bargaining for consideration commensurate with its chosen level of diligence. Be mindful, however, that Centro and Arfa both involved sophisticated business owners on both sides of the transactions with prior histories of strife and mistrust. Take away those elements and it still may be possible for a business owner to overcome a release given in connection with a buy-out or other agreement based on alleged failure by a fiduciary to disclose material information.
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.
Update October 12, 2010: Today the Appellate Division, First Department, granted a motion by Arfa/Shpigel for leave to appeal to the New York Court of Appeals, where it will join the already pending Centro appeal.
Update May 2, 2011: The oral argument of the appeal in Arfa to the Court of Appeals was heard on April 27, 2011. Click here to watch the video.
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.
Update May 2, 2011: The oral argument of the appeal in Centro to the Court of Appeals was heard on April 27, 2011. Click here to watch the video.
Fiduciaries, the Duty to Disclose and the Incredible Shrinking Release
As a matter of public policy, we want people to settle their disputes without resort to courts. Enforceability and finality are the twin pillars of settlements. General releases in settlement agreements advance the goals of dispute resolution by encouraging due diligence by the releasor and by fixing the releasee's exposure.
The law of fiduciaries can complicate dispute resolution among business partners, and occasionally clashes with the settlement goals of enforceability, finality, diligence and certainty.
I wrote about such a clash earlier this year in the case of Littman v. Magee (read here). In Littman, an appellate court permitted a damages suit by a minority member of an LLC, brought over a year after he sold his interest to the controlling members allegedly at an artificially low price, to recover the "true value" of his interest based on financial information allegedly withheld from him at the time of sale. The court refused to give effect to a general release in the buyout agreement, expressly covering claims known and unknown, citing the controlling members' fiduciary duty to disclose all material facts bearing on the transaction. As I wrote at the time, Littman struck me as "lowering the bar" for claims of tainted buyout by former business partners.
A recent trial court ruling in a case called Arfa v. Zamir illustrates the Littman rationale's potential reach beyond the buyout context, and raises new questions about the utility of releases in out-of-court settlement agreements between business partners.
Arfa is a convoluted, multi-layered litigation among the controlling members of a series of real estate holding companies organized as LLCs, outside investors who intervened in the case, and a court-appointed temporary receiver. The case is assigned to New York County Commercial Division Justice Charles E. Ramos who wrote a helpful summary of the factual background in an earlier decision dated September 8, 2008 (21 Misc3d 1101(A)).
The plaintiffs, Rachel Arfa and her husband, Alexander Shpigel, filed a 54-page Second Amended Complaint which includes a Fifth Cause of Action for fraud against defendant Gadi Zamir relating to one of the realty venture's acquisitions known as Academy Street. The plaintiffs allege that in late 2004, Zamir recommended that the parties acquire Academy Street based on various income and expense projections, and that in reliance on Zamir's recommendation and presentations they approved the deal which closed in April 2005. Plaintiffs allege that in the summer of 2005, they learned of serious problems with the building's physical condition which allegedly were known to Zamir and withheld from plaintiffs at the time Zamir solicited their approval.
Meanwhile, plaintiffs and Zamir entered into a Governance Agreement dated June 9, 2005, which was intended to resolve growing frictions between them over management and control of the entire real estate portfolio. The plaintiffs allege that they "reluctantly agreed" to Zamir's "demand" that they enter into the Governance Agreement "to appease Zamir and prevent him from destroying the value of the real estate portfolio . . .." Mutual veto power over management decisions appears to be the main thrust of the Governance Agreement. The Governance Agreement also contains a mutual general release in which the parties release one another from "any and all claims . . . known or unknown" arising from events that pre-date the Governance Agreement.
Zamir moved to dismiss the fraud claim based on the release. As summarized in Justice Ramos's decision denying the motion dated December 8, 2008 (2008 NY Slip Op 33348(U)), the plaintiffs argued that
to the extent that Zamir owed Plaintiffs a fiduciary duty by virtue of being co-managers, he may not rely upon the Release to insulate himself from liability where he intentionally concealed from Plaintiffs the physical condition of the Academy Street Property, and which misrepresentation was an inducement to enter into the release from the outset.
Justice Ramos agreed with plaintiffs, citing Littman for the proposition that "a fiduciary cannot, by a general release, insulate itself of its fiduciary obligation of full disclosure by wrongfully withholding the very information that a party requires to make a reasoned judgment on whether to agree to the general release at the outset." The decision continues:
As a fiduciary, Zamir was under an affirmative duty to disclose any information that could reasonably bear on Plaintiffs' consideration to enter into the general release (Littman, 54 AD3d at 18). Accepting the [Second Amended Complaint's] allegations as true, as the Court must do at this stage, Zamir failed to disclose to Plaintiffs vital material facts in order to permit them to make a reasoned judgment as to whether to agree to the terms of the Release. In addition to failing to disclose to Plaintiffs, it is alleged that Zamir intentionally concealed from Plaintiffs material facts, including the engineering reports' findings concerning the structural defects in the property, and the Violations Undertaking.
I don't know whether the plaintiffs were facing potential claims by Zamir when they executed the Governance Agreement with mutual general releases. In any event, I have to assume that Zamir bargained for the release as part of the consideration for whatever concessions he made in the Governance Agreement. Had he understood that the release would not shield him from future claims based on alleged nondisclosures concerning Academy Street or any of their other real estate projects, would he have entered into the Governance Agreement? Obviously I can't answer the question or speculate whether it would have induced him to make additional disclosures that may or may not have soured the deal. The broader question, which I'll also leave for others to answer, is whether it makes sense, and at what cost to public policy favoring out-of-court settlement, to expand the fiduciary exception to enforcement of general releases based on an intrinsically amorphous duty of disclosure.
Update July 19, 2010: The First Department handed down two decisions in June and July 2010 significantly pruning Littman's broad pronouncements. One of those decisions reverses the lower court's Arfa ruling discussed above. Read here the first of two posts on the subject, highlighting the First Department's decision last month in the Centro Empresarial case.
Update July 29, 2010: Read here the second post discussing the First Department's July 13, 2010, decision reversing Justice Ramos's above-discussed ruling in Arfa.
Decision Lowers the Bar for Former Partner's Claims of Fraudulent Buyout
When non-controlling partner A sells out to controlling partner B, following which B sells the company to a third party at a disproportionately high premium over A's price, A may suspect that B withheld information pertaining to the company's value at the time of A's sale. The question is, does A have a valid claim against B to recover a share of the re-sale profits? Does caveat venditor give way to a fiduciary-based, affirmative obligation on B's part to disclose to A any and all information material to the sale price?
An opinion handed down last week by an appellate court in Manhattan appears to lower the bar for such a lawsuit, and sends a cautionary message to transactional counsel concerning the effectiveness of seller representations and releases in partner buyout agreements.
In Littman v. Magee, 54 AD3d 14 (1st Dept 2008), Steven Littman held an 18.7% membership interest in Rockwood Realty Associates LLC, a real estate investment firm formed in 1996 and managed by another LLC controlled by Rockwood's majority owners. Littman's 28-page complaint essentially alleged that the majority owners engaged in a squeeze-out through property sales that forced Littman to incur large personal tax bills on undistributed K-1 profits, contrary to an alleged "understanding" when the company was formed that distributions sufficient to cover taxes would be made.
In late 2004, one of the defendants initiated buyout discussions with Littman, allegedly telling him that the company's profits that year would result in substantial tax obligations but that no tax distributions would be made to members. In response to Littman's requests for financial information, he received an internal balance sheet and income statement for the nine months ended September 2004, and tax returns and financial statements for 2002 and 2003. In response to Littman's further requests for information on projected values, allegedly one of the defendants replied that "no other information was or would be made available".
In April 2005, Littman agreed to sell his interest for over $2 million. Littman was represented by an attorney and also had the assistance of his own accountant. The agreement contained Littman's representation that he had "such knowledge and experience in financial and business matters such that [he] is capable of evaluating the terms and provisions of this Agreement and the other Transaction Documents". He also executed a general release containing an acknowledgment that he
is aware that [he] may hereafter discover claims presently unknown or unsuspected, or facts in addition to or different from those which [he] now know[s] or believe[s] to be true, with respect to the matters released herein.
A little over a year later, in May 2006, Rockwood announced that a publicly held British company, DTZ Holdings PLC, had acquired for $45 million plus other consideration a 50% interest in Rockwood, which changed its name to DTZ Rockwood. A month later Littman filed his lawsuit asserting claims for breach of fiduciary duty and to declare his release void. Littman alleged that defendants concealed information in their possession concerning the prospects of Rockwood, and sought damages over $16 million representing the supposed difference between what he was paid and his proportionate share of Rockwood's "true value" as of April 2005.
The trial court's decision, authored by Justice Bernard J. Fried of the New York County Supreme Court, Commercial Division, granted the defendants' dismissal motion. Justice Fried found that Littman's claims were barred by his release which "refers to the specific subject matter as to which the representations are alleged, with precise specificity to put the plaintiff Littman on notice as to the clause's intended effect". Furthermore, Justice Fried concluded, Littman was put on "inquiry notice" of his potential claims for misrepresenting Rockwood's profitability when the defendants rebuffed his specific requests for projected values.
The appellate court disagreed and reinstated Littman's complaint. The court's opinion, written by Associate Justice David B. Saxe, states that
defendants, as shareholders, and particularly as active managing shareholders in a closely held corporation, owed a fiduciary duty to plaintiff, a minority shareholder. Plaintiff was therefore entitled to expect defendants to disclose any information in their possession that could reasonably bear on his consideration of defendants' offer, since "when a fiduciary, in furtherance of its individual interests, deals with the beneficiary of the duty in a matter relating to the fiduciary relationship, the fiduciary is strictly obligated to make full disclosure of all material facts". [Citations omitted.]
The internal quote is from a much-cited case called Blue Chip Emerald LLC v. Allied Partners, Inc., 299 AD2d 278 (1st Dept 2002), in which the appellate court upheld a complaint for fraud and breach of fiduciary duty brought by 50% partners in a real estate partnership who sold their interest to the other partners based on an $80 million valuation when the other partners already had received -- but did not disclose to the plaintiffs -- a $200 million third-party offer which they accepted shortly after the partner transaction.
In opposing Littman's appeal, the defendants argued that Littman in his complaint acknowledged that the information they provided to him was insufficient for him to properly value his interest in the company, and thus he could not have relied on the defendants' alleged misrepresentations or omissions. The court rejected this argument, stating that "the crux of plaintiff's claim is that [defendants] misinformed him that there were no other financial documents, forcing him to proceed with the evaluation with the limited information they made available, when they possessed other vital information".
The court also gave short shrift to defendants' argument based on the acknowledgment contained in Littman's release, of claims and information "unknown", stating that while such language may be effective in an arm's length business transaction, it does not preclude a claim against a fiduciary with a duty to disclose "all material facts bearing on the transaction".
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? The sale of Rockwood to DTZ occurred about 13 months after Littman's deal. Would it have made a difference if the DTZ transaction came two years later? Three years later? For that matter, under the decision's fiduciary rationale, wouldn't Littman have the same right to recover the "true value" of his interest even if there had never been a subsequent third-party sale? If so, Littman appears to go well beyond the Blue Chip case, where the defendant partners were accused of concealing a superior third-party offer at the very same time they were negotiating the partner buyout.
More questions: Would the outcome have been different if, in response to Littman's requests for projections, the defendants simply refused to provide them instead of (allegedly) denying that they had any? What if Littman's agreement had explicitly identified the limited financial information given to him, and explicitly represented that Littman was not relying on any other information in the buyer's possession known or unknown to Littman? Would such language preclude allegations of reliance and thereby enable dismissal of a complaint at the pre-discovery stage? These questions, and many others raised by Littman, will have to await further case law developments.
Update July 19, 2010: The First Department handed down two decisions in June and July 2010 significantly pruning Littman's broad pronouncements. Read here the first of two posts on the subject, highlighting the First Department's decision last month in the Centro Empresarial case.
