With a Whimper, Not a Bang: New York's Top Court Rules on LLC Promoter Liability
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One of the benefits of writing a law blog is getting to know and exchange ideas, case notes and legal tidbits with other lawyers and academics. I am grateful that in this fashion I got to know Professor Larry Ribstein, who passed away unexpectedly last weekend at the peak of his prolific, dazzling career as a leading academic voice and mentor to many in diverse fields of business law and particularly in the area of unincorporated business entities. He had a giant intellect and a forceful style that pulled no punches. He was, as I described him to others, scary smart. Two years ago, on the occasion of the publication of his brilliant book, The Rise of the Uncorporation, he graciously agreed to be interviewed for this blog (read here). His last message to me was an email forwarding a post he wrote about the New York Court of Appeals' decision last week in the Roni LLC v. Arfa case discussed below, in which with typical and well-earned bravado he credits his amicus brief filed in that case with influencing the outcome. Undoubtedly, his influence and legacy of provocative scholarship will be felt and carried forward by many for a long, long time. |
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Last week the judges of the New York Court of Appeals unanimously affirmed the Appellate Division, First Department's interlocutory order in Roni LLC v. Arfa denying a motion to dismiss investors' claim for breach of fiduciary duty against the organizers or "promoters" of a series of real estate holding limited liability companies allegedly for failing to disclose, prior to formation of the LLCs, millions of dollars in brokerage commissions to be paid to the promoters. Roni LLC v. Arfa, 2011 NY Slip Op 09163 (Ct App Dec. 20, 2011).
The First Department's controversial ruling held, by analogy to 19th century cases imposing fiduciary obligations on stock corporation promoters, that promoters of LLCs by virtue of their status as such also take on fiduciary duties of disclosure to prospective investors. Before reaching the issue, the court specifically found that the complaint failed to allege, as an alternative basis for finding a fiduciary duty, that the defendants possessed superior expertise or knowledge about the real estate transactions coupled with false representations concerning that subject, or that defendants' personal connections with the plaintiffs established a fiduciary relationship. (Read here my account of the First Department's decision.)
When the case was argued before the Court of Appeals last month (read about it here), a number of the judges' questions suggested discomfort with the First Department's status-based rationale for promoter liability, while others suggested an approach to the fiduciary question not tied to promoter status but instead based on the more traditional approach keyed to the defendants' control and domination over the pre-formation enterprise.
Those hoping for a big showdown on the status-based rationale adopted by the First Department will be disappointed to read the Court of Appeals' decision. Stating that a fiduciary relationship exists "when confidence is reposed on one side and there is resulting superiority and influence on the other," the Court holds that the plaintiffs' complaint adequately alleges that "defendants planned the business venture, organized the limited liability companies, solicited their involvement and exercised control over the invested funds." The Court explains further:
We agree with plaintiffs that the promoters of a limited liability company are in the best position to disclose material facts to investors and can reveal those facts more efficiently than individual investors, who would otherwise incur expense investigating what the promoters already know. In addition, the complaint alleges that the promoter defendants represented to the foreign investors that they had "particular experience and expertise" in the New York real estate market. Although the promoter defendants describe plaintiffs as "sophisticated prospective investors," the complaint paints a different picture, stating that they were "overseas investors who had little or limited knowledge of New York real estate or United States laws, customs or business practices with respect to real estate or investments." Moreover, plaintiffs contend that the promoter defendants assumed a position of trust and confidence, in part, by "playing upon the cultural identities and friendship" of plaintiffs. Accepting the totality of these allegations to be true, as we must at this early stage of the litigation, the complaint adequately pleads a fiduciary relationship.
Trust and confidence? Playing upon the friendship of plaintiffs? Didn't the First Department hold that the complaint failed to plead a fiduciary relationship on those bases? The Court of Appeals makes no mention of it, nor does it acknowledge the defendants' argument that the Court of Appeals lacks jurisdiction on an interlocutory appeal to upset the First Department's holding on those points.
And what of the First Department's holding based on promoter status? The Court essentially punts the question whether a promoter as such owes a fiduciary duty, writing in a footnote that "[b]ased on the foregoing analysis, we need not decide the question of whether the promoter defendants' status as organizers of the limited liability companies, standing alone, was sufficient to allege a fiduciary relationship."
The late Professor Ribstein, who filed an amicus brief in the case supporting defendants' position, commented in one of his last blog posts that "the Court of Appeals, without saying so directly, effectively rejected the lower court’s determination that the complaint had not alleged a fiduciary relationship. The Court did so in order to avoid a holding in favor of promoter liability that would, I argued, 'make a mess out of NY LLC law.'" Professor Ribstein also took satisfaction from another footnote in the Court of Appeals' decision:
In its opinion, the Court recognized (n. 1) that “[c]ertainly, there are differences between limited liability companies and traditional corporations, but the distinctions are not relevant to the allegations in this case.” They were not relevant because the Court strained to accept the alternative basis for a fiduciary duty the lower court had rejected. In short, I invited the Court not to wreck NY LLC law by imposing open-ended pre-formation promoter liability. The Court accepted my invitation although this forced it to weave a circuitous course around the lower court’s opinion.
Doubtless there's some future plaintiff out there who, undeterred by the Court of Appeals' inconclusive handling of the issue, will bring another LLC promoter liability case based solely on promoter status. And when that happens, we shall see if Professor Ribstein's assessment proves correct.
Update January 6, 2012: Read here Doug Batey's take on the Roni decision.
NY's Top Court Hears Argument on LLC Promoter Liability
On November 15, 2011, the spectacular Albany courtroom pictured at left was the setting for oral argument before the New York Court of Appeals in Roni LLC v. Arfa, No. 228, in which the court is poised to decide whether pre-formation limited liability company "promoters" have a fiduciary duty of disclosure to potential investors. The outcome could have a significant impact on investment structure and investor solicitation, especially in the real estate industry where the LLC, for tax and other reasons, is the preferred form of business organization.
The case involves claims by a group of Israeli real estate investors who purchased membership interests in a series of LLCs formed to acquire, renovate, manage and eventually re-sell multi-family residential properties in New York City. The complaint's gravamen is that the defendants, who identified the properties, solicited investors, organized the LLCs, negotiated the acquisitions and obtained mortgage financing, concealed from the plaintiffs certain "brokerage" fees of up to 15% that the defendants were to receive from the property sellers and mortgage brokers, eventually exceeding $6.5 million. The plaintiffs alleged that the defendants as "promoters" of the to-be-formed LLCs had a fiduciary duty to disclose the brokerage arrangement to the plaintiffs as prospective investors, and that the fees inflated the purchase prices paid for the properties to plaintiffs' financial detriment.
The trial court denied defendants' motion to dismiss the complaint. In a June 2010 decision which I reported on here, the intermediate appellate court held that the complaint's allegations did not state a traditional claim for breach of fiduciary duty based on a business or personal relationship of trust and confidence, superior expertise and knowledge. The court nonetheless upheld the denial of the defendants' dismissal motion based on the defendants' "status as the organizers of the business venture", explaining as follows:
[P]laintiffs' allegations that the promoter defendants planned the business venture, organized the LLCs, and solicited plaintiffs to invest in them are sufficient to establish a fiduciary relationship. It is well settled that both before and after a corporation comes into existence, its promoter acts as the fiduciary of that corporation and its present and anticipated shareholders. By extension, the organizer of a limited liability company is a fiduciary of the investors it solicits to become members. The fiduciary duty includes the obligation to disclose fully any interests of the promoter that might affect the company and its members, including profits that the promoter makes from organizing the company. Accordingly, plaintiffs stated a cause of action for breach of fiduciary duty by alleging that the promoter defendants failed to reveal that they would receive commissions from sellers and mortgage brokers in addition to their other, disclosed, profit from the venture. [Citations omitted.]
The Briefs
In September 2010, the intermediate appellate court granted the defendants' motion for leave to appeal to the state's highest court, the New York Court of Appeals.
The defendants' brief filed in the Court of Appeals (read here) argues:
- the 19th century case authorities relied on by the lower court, involving promoters of corporations, did not establish a per se rule that promoters were fiduciaries as a matter of law;
- those authorities require a relationship of trust and confidence which the lower court expressly found lacking in Roni; and
- even if the old authorities did create a status-based rule for corporation promoters, it should not be applied to persons who organize LLCs.
The last point contrasts the discretion and control exercised by corporation organizers in creating the initial governance structures (i.e., articles of incorporation and bylaws) and deciding how to use investor money, with the contract-based LLC form in which governance and capital structures are set forth in written, fully integrated operating agreements executed by the investors.
The plaintiffs' opposing brief (read here) argues:
- the defendants' control of the investors' funds and management of the enterprise in the period prior to formation of the LLCs give rise to a fiduciary duty of disclosure of "hidden commissions";
- the common law rules governing corporation promoters as a matter of legal theory and policy should extend to LLC promoters; and
- in the alternative, the intermediate appellate court erred in holding that the complaint failed to allege a fiduciary relationship based on the defendants' special knowledge and real estate expertise coupled with the defendants' solicitation of overseas investors through personal relationships and "cultural affinity".
Professor Larry Ribstein, a leading authority on LLC and partnership law, filed an amicus brief in support of the defendants' position (read here), in which he argues:
- the intermediate appellate court's holding in favor of fiduciary duty of disclosure of organizers of LLCs is unprecedented in the law of LLCs;
- the NY LLC Law's provisions governing organizers and managers do not support a status-based fiduciary obligation for the former; and
- the old corporate promoter cases, even if not made "dead letter" by federal and state securities laws, should not be applied to establish pre-formation duties in LLCs, among other reasons, because unlike corporations, LLCs are "creatures of contract" that do not present "a potential for abuse comparable to that of large business entities seeking capital from hundreds or thousands of small investors."
The Oral Argument
If you click here, you can view a video webcast of the oral argument in Roni held on November 15, 2011. But first, you'll need some navigational aid.
The Court of Appeals combined oral argument in Roni with a second case, Assured Guaranty (UK) Ltd. v. J.P. Morgan Investment Management Inc., No. 227, due to the circumstance that both cases raise issues involving a preemption defense under the anti-fraud provisions of New York's Martin Act governing the sale of publicly offered securities. The entire argument lasts an hour. If you'd like to view the Roni portion of the webcast, click on the first entry on the November 15 calendar and, once the video opens, advance to the 27 minute mark for argument by defendants' counsel immediately followed by plaintiffs' counsel until the 45 minute mark. Defendants' counsel's rebuttal argument picks up at the 58 minute mark and goes just a few minutes to the end of the session. In the summary that follows, numbers in parentheses refer to the minute and second marks in the video.
Four of the six judges who heard the argument (Judge Smith recused himself) questioned the attorneys in Roni, with Chief Judge Lippman being the most active inquisitor. Early in defense counsel's argument (28:20), Judge Lippman set a somewhat skeptical tone with the questions, "What is the fact that it's an LLC have to do with the fiduciary duty issue?" and "Why should LLCs be treated differently?" to which defense counsel answered, LLCs are based on contractual relations established by the parties in the operating agreement and, therefore, at the pre-formation stage there is no point at which one can say the fiduciary relationship begins and ends.
Judge Graffeo queried (29:15) if the intermediate appellate court "went too far" in drawing such a close comparison between the corporate realm and LLCs, with which defense counsel readily agreed, stating that absent allegations of a relationship of trust and confidence, superior skill and knowledge, there can be no fiduciary obligation imposed on a promoter of a corporation or an LLC, and if there's no fiduciary relationship, the promoter has no duty to disclose a pre-formation commission arrangement like the one in Roni.
Judges Graffeo (31:50) and Pigott (32:40) asked several questions focused on the adequacy of the complaint, and whether the plaintiffs in Roni sufficiently alleged for pleading purposes a fiduciary relationship based on the plaintiffs' foreign residence and their dependence on the real estate expertise of the defendants, to which defense counsel replied that, in an interlocutory appeal (as opposed to an appeal from a final judgment), the Court of Appeals lacks jurisdiction to review the intermediate appellate court's ruling that the complaint fails to plead the traditional badges of a fiduciary relationship.
Plaintiffs' counsel was met by questions from Judge Lippman (35:05) as to the basis for the alleged fiduciary relationship and if it matters "whether you're an LLC or not?" Plaintiffs' counsel replied that the business form does not matter ("not at the starting gate yet") and that the "control and domination" exercised by defendants over the pre-formation enterprise imposes fiduciary duties of disclosure.
Judge Ciparick asked (37:20) whether the purchase prices of the real properties were inflated by the secret commissions, to which plaintiffs' counsel answered "Yes, absolutely" and that the plaintiffs consequently suffered a direct, out-of-pocket loss.
Judge Graffeo then asked (39:30) whether an undisclosed commission, standing alone, creates a fiduciary relationship and, if other factors must be pleaded, whether the Court of Appeals has jurisdiction to review the finding below that the complaint did not adequately allege the traditional fiduciary badges. Plaintiffs' counsel responded that a claim based on undisclosed commission is stated where the promoters solicited investors, controlled the funds and controlled the properties, and that the Court of Appeals has jurisdiction to affirm the decision below on an alternative ground.
Judge Pigott next asked (41:50), "Is there any limit to this?" and "Can you bring a case similar to this on almost any set of facts in which someone is dissatisfied with the amount of the return they got?" Plaintiffs' counsel suggested in reply that such cases are limited to ones where the promoter sells the investment, controls the investment funds pre-formation, and where the alleged non-disclosure -- here, the $6.5 million in commissions -- is material to the decision to invest.
Judge Pigott then pressed counsel (43:25) to identify the source of the alleged fiduciary duty in Roni, to which plaintiffs' counsel replied that it stems from the defendant promoters' soliciting the investment, taking the investors' money, controlling the expenditure of the monies, hiring counsel for the enterprise, arranging financing for the acquisitions, and managing the properties, to which Judge Pigott responded (44:00), "That's kind of where I'm looking for the line drawing because if you have a situation where each one of those is a fiduciary obligation, each one could be a cause of action for breach of fiduciary duty."
In his rebuttal argument (58:00), defendants' counsel contended that his clients did not exercise control and domination over the investments, and that they were required to use investor funds in the manner specified in the written promotional materials provided to the plaintiffs. Judge Lippman asked (59:25), "What about the concealment of the 15% fee?" to which defendants' counsel replied that the defendants were not disputing concealment for purposes of the dismissal motion but that, without an independent basis for imposing a fiduciary duty, the concealed fees could not give rise to liability.
Will New York be the first state to adopt a status-based rule holding LLC promoters to a fiduciary standard? If not, will the Court of Appeals nonetheless affirm on the ground that the complaint adequately pleads a fiduciary relationship based on control and domination or, contrariwise, will it dismiss the fiduciary breach claim on the basis it has no jurisdiction to review the intermediate appellate court's conclusion that the complaint does not plead a fiduciary relationship other than based on the defendants' status as promoters?
We'll likely have to wait until the early months of next year for the answer, though that may also depend on how long the Court takes to decide the related appeal in the Assured Guaranty case. Indeed, if the Court in that case and in Roni holds that the Martin Act preempts the plaintiffs' common law claims, the LLC promoter liability issue in Roni likely will be mooted.
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.
