The Rise and Fall and Rise of Blue Chip: Fiduciary Duty Trumps Waiver in Latest First Department Decision
.jpg)
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.
May Majority Member of Managerless Manager-Managed LLC Maintain Derivative Action?
A limited liability company named Ocelot Capital Management, LLC made some new law last month on a narrow but interesting issue: Can the majority member of a manager-managed New York LLC bring a derivative action on its behalf when the manager position is vacant, without alleging either a prior demand upon the manager or that such demand would be futile?
The question drew a negative answer from New York County Commercial Division Justice Bernard J. Fried, who consequently dismissed the derivative claims in Eldan-Tech, Inc. v. Ocelot Capital Management, LLC, Memorandum Decision, Index No. 651101/10 (Sup Ct NY County Oct. 29, 2010).
The dispute in Ocelot begins with a $350,000 promissory note made by Isaac Hershkovitz in favor of Ocelot Portfolio Holdings, LLC ("OPH") given in partial payment for Hershkovitz's purchase from Holdings of the latter's ownership interest in another real estate holding company known as OCG VI. According to its operating agreement, OPH is a manager-managed LLC whose membership interests are held 80% by plaintiff Eldan-Tech, Inc. ("Eldan") and 20% by defendant Ocelot Capital Management, LLC ("OCM"). OCM, which was OPH's sole manager, is wholly owned by Rachel Arfa and her husband. At that time Arfa also was the sole officer and director of Eldan.
The day after the note was made, Arfa as manager of OCM and as sole officer and director of Eldan caused OPH to assign the note to OCM. Several months later, Arfa was removed as an officer and director of Eldan, and OCM was removed as the manager of OPH.
Eldan as 80% member of OPH subsequently filed a complaint asserting a pair of derivative claims on OPH's behalf alleging that Arfa wrongfully caused the sale of OCG VI from OPH to Hershkovitz and "pocketed the proceeds" by assigning the note to OCM and later recovering a judgment on the note in OCM's favor. (Read the complaint here.)
OCM moved to dismiss the complaint on the ground Eldan lacks standing to assert derivative claims because its complaint fails to plead that a prior demand was made on OPH's "board" or that such demand would be futile. OCM contended that under OPH's operating agreement, Eldan had unfettered authority both to remove and to appoint the manager of OPH, hence nothing prevented Eldan from causing OPH to bring an action against OCM in OPH's own name. OCM further suggested that Eldan, a company based in Israel, deliberately chose not to appoint a new manager for OPH because none of its representatives wished to take on the fiduciary duties attendant to the position or to submit themselves to personal jurisdiction in New York. (Read OCM's opening and reply memoranda of law here and here.)
In opposing the motion, Eldan argued that the demand requirement for derivative actions on behalf of LLCs applies only to minority members, and not to a majority member such as itself. Eldan described the New York Court of Appeals' 2008 decision in Tzolis v. Wolff, which recognized a common law right to sue derivatively on behalf of an LLC (read here my post on Tzolis), as creating a "permissive" right to sue derivatively but not "requiring" a majority member "to file suits individually." Eldan also contended that it was unable to make a demand because the person it appointed to replace OCM as manager resigned from the position several months later. (Read Eldan's opposition brief here.)
Justice Fried's legal analysis cites post-Tzolis cases, including Evans v. Perl, 19 Misc3d 1119(A) (Sup Ct NY County 2008), and Billings v. Bridgepoint Partners, LLC, 21 Misc3d 535 (Sup Ct Erie County 2008), in which the courts held that the long-established demand requirements for statutory derivative actions involving corporations also apply to LLC common law derivative actions. (Read here my post on the Evans and Billings cases.) Eldan's complaint, he continues, fails to comply with this rule in that it alleges neither the making of a demand nor that doing so would have been futile. So while Eldan is correct that Tzolis allows Eldan to bring a derivative action, "the demand requirement still must be met." The fact that OPH has no manager, Justice Fried adds, does not permit Eldan as majority member to act on OPH's behalf when OPH, as provided in its operating agreement, "is a manager-managed as opposed to member-managed LLC, and such conduct by Eldan would be contrary to that Agreement." The court accordingly concludes that Eldan "lacks standing to bring a derivative claim on behalf of OPH."
I can imagine circumstances where, due to disproportionate allocation of voting power or a super-majority voting requirement in the operating agreement, a majority member of a manager-managed LLC might have to bring a derivative action. But even so, I can't think of a logical reason for an exemption from the demand requirements which are founded on the notion that the decision to bring suit belongs to the company through its governing body.
Update December 8, 2011: The Appellate Division, First Department, today denied Eldan's appeal from Justice Fried's ruling, stating that Eldan's "argument that the demand requirement was inapplicable because it had a majority equity interest in OPH, as opposed to a minority interest, is unavailing. BCL 626(c) does not differentiate between minority and majority shareholders for demand purposes. Moreover, the enumerated exceptions to the demand requirement have not been shown to be applicable here." The appellate decision is reported at 2011 NY Slip Op 08830.
Does Operating Agreement's Clause Permitting Competitive Activities Eliminate Member's Fiduciary Duty to Disclose Negotiations to Sell LLC's Assets Before Buying Out Co-Members?
The question posed by this post's title derives from an unpublished decision earlier this month in a case called Pappas v. Tzolis, Mem. Dec., Index No. 601115/09 (Sup Ct NY County Mar. 3, 2010). The case involves a real estate LLC whose operating agreement included a frequently used "Other Activities" clause expressly authorizing the members to engage in competitive business ventures. One member bought out the other two, allegedly while he was secretly negotiating with an unrelated outside buyer of the LLC's sole asset. The sale took place about six months after the member buyout for a price far in excess of what the former members received. The court dismissed the former members' complaint alleging that the failure to disclose the negotiations with the outside buyer breached fiduciary duty, holding that the Other Activities clause eliminated fiduciary duty.
Pappas raises several interesting questions, the first of which has two parts: (a) what law determines fiduciary obligations in a Delaware LLC whose operating agreement expressly provides that it is to be governed by New York substantive law, and (b) why would parties form a Delaware LLC but opt to apply New York law? Second, under either state's law, can the members completely eliminate a fiduciary duty of disclosure of the sort alleged in Pappas? Third, did the specific language of the operating agreement's clause permitting competition eliminate such duty? Complicated issues all, the answers to which could occupy a law review article.
According to the complaint in Pappas (read here), in January 2006 the two plaintiffs and defendant Steve Tzolis formed Vrahos LLC as a Delaware limited liability company to renovate and lease space in a Manhattan commercial building under a 49-year net lease acquired by the LLC. Tzolis owned a 40% interest and the plaintiffs held the other 60%. (Yes, trivia fans, this is the same Tzolis of Tzolis v. Wolff fame.)
Around March 2006, the parties finalized and executed an operating agreement (read here) that contemplated subleasing the building to Tzolis at a rent $4.00 per square foot in excess of the rent due the building's owner under the prime lease, such excess amounting to about $20,000 per month. Section 10 of the operating agreement designated all three members as managers of the LLC and required unanimity on all decisions and actions required or permitted to be taken by the managers. Section 11, entitled "Other Activities of Members," provided as follows:
Any Member may engage in business ventures and investments of any nature whatsoever, whether or not in competition with the LLC, without obligation of any kind to the LLC or to the other Members.
Section 12 of the operating agreement, entitled "Liability of the Members," provided that no member:
shall be liable to the LLC or to any other person or entity for any act or omission performed or omitted by such Member in good faith pursuant to the authority granted such Member or Manager by this Agreement, other than acts of fraud, bad faith or willful tortious misconduct.
Notwithstanding that the LLC was formed in Delaware, Section 15 of the operating agreement, entitled "Applicable Law," provided that "[t]his Agreement shall be governed and construed under the substantive laws of the State of New York."
Plaintiffs alleged that after taking over the building Tzolis failed to pay the additional sublease rent to the LLC and instead proposed a buyout of the plaintiffs' interests for the combined sum of $1.5 million, which they accepted in January 2007 after which Tzolis became the LLC's sole member. The buyout documentation included a "Certificate" executed by the plaintiffs stating that "each of the undersigned sellers agrees that Steve Tzolis has no fiduciary duty to the undersigned sellers in connection with [the sales of their interests]."
Plaintiffs further alleged that, prior to January 2007, Tzolis entered into secret discussions with the Extell Development Company to transfer the lease to an Extell affiliate for $17.5 million, which transfer took place in August 2007. The complaint asserts, among other claims, that Tzolis breached fiduciary duty and the implied contractual duty of good faith and fair dealing by failing to disclose the opportunity to sell the lease to Extell.
Tzolis moved to dismiss the complaint. In his memorandum of law (read here), he argued that because the LLC was formed in Delaware, that state's law governed the LLC's internal affairs and that under Delaware law, the parties were free to, and did in Section 11, eliminate any alleged fiduciary duty of disclosure to the plaintiffs surrounding Tzolis's dealings with Extell.
The plaintiffs' opposing memorandum of law (read here) contended that the court was obligated to respect the New York choice-of-law provision in Section 15 of the operating agreement; that New York law as pronounced in Blue Chip Emerald LLC v. Allied Partners, Inc., 299 AD2d 278 (1st Dept 2002), imposed upon Tzolis a duty to disclose his alleged negotiations with Extell; and that the Other Activities clause in Section 11 of the operating agreement did not constitute a waiver of fiduciary duty concerning transactions involving the subject LLC, but only as to outside business activities.
The decision written by Judicial Hearing Officer Ira Gammerman agreed with Tzolis and dismissed the complaint. Addressing initially the choice of law question, JHO Gammerman ruled that '[f]or purposes of deciding this motion, I need not decide which law to apply, because the result is the same, under both Delaware and New York law."
Next, as to plaintiffs' allegation that Tzolis fraudulently induced them to sign the Certificate waiving fiduciary duty in connection with the sale of their interests to Tzolis, JHO Gammerman noted that Tzolis was not relying on the Certificate as effecting a waiver. Rather, he wrote, Tzolis relied on the Certificate only to the extent of "evincing and certifying the absence of any such duties on his part" as a result of the pre-existing waiver set forth in Section 11 of the operating agreement.
Then comes the heart of the ruling, in which JHO Gammerman held that Section 11 "eliminates the fiduciary relationship that would, otherwise, be owed by the members to each other . . .." JHO Gammerman rejected plaintiffs' reliance on the Blue Chip Emerald case where the appeals court reinstated fiduciary breach and fraud claims by a member of a Delaware LLC that owned New York realty. That case likewise involved a buyout of one member by another, followed by a sale of the property at a price far above the valuation given to the selling member at the time of the buyout. The court there stressed that the buying member was a fiduciary "until the very moment the buy-out transaction closed" and therefore was obligated to disclose any information that could reasonably bear on the selling member's consideration of the buying member's offer including the latter's knowledge of an outside buyer's higher offer. JHO Gammerman found that, "by contrast, the parties [in Pappas] agreed [in Section 11] that, from the start of the LLC, they would have no fiduciary duty to it, or to each other."
JHO Gammerman also observed that § 18-1101(c) of the Delaware LLC Act explicitly authorizes elimination of fiduciary duties in the operating agreement, and that "[s]imilarly, under New York law, parties are free to contract as they wish, so long as the terms of their contract are neither unlawful, nor in violation of public policy." The decision does not mention the mandatory provision in § 409(a) of the New York LLC Law imposing on managers an obligation to "perform his or her duties as a manager . . . in good faith and with that degree of care that an ordinarily prudent person in a like position would use under similar circumstances."
The fiduciary duty implicated by Section 11 of the operating agreement in Pappas is one of loyalty, which is not expressly mentioned in § 409. What about the statute's reference to "good faith"? I'm not aware of any court ruling in the LLC context construing "good faith" as used in the statute. On the other hand, § 409's language is lifted verbatim from § 717(a) of the Business Corporation Law governing duties of corporate directors. In Foley v. D'Agostino, 21 AD2d 60 (1st Dept 1964), an intermediate appellate court interpreted "good faith" as used in the latter statute as meaning:
[Directors] may not assume and engage in the promotion of personal interests which are incompatible with the superior interests of their corporation. (See 19 C. J. S., Corporations, § 761, and cases cited.) "Officers and directors of a corporation owe it to their undivided and unqualified loyalty. * * * They should never be permitted to profit personally at the expense of the corporation. Nor must they allow their private interests to conflict with the corporate interests. These are elementary rules of equity and business morality. Courts of equity must ever enforce strict compliance with these rules."
So if good faith has the same meaning for purposes of § 409 as it does for § 717, inclusive of the duty of loyalty, does Section 11 in the Pappas agreement contravene the statute?
Assuming it doesn't, and that JHO Gammerman therefore also is correct in concluding that New York and Delaware law do not differ on the issue of permissive waiver, I come back to the question whether the specific language used in Section 11 eliminates the fiduciary duty that otherwise would exist. Such competition clauses are commonly found in agreements among co-owners of real estate companies where the individual owners may be involved in any number of other ventures on their own or with different business partners, some of which may be competing in the same market for tenants, services and finance. Do such provisions encompass self-dealing with respect to insider transactions involving the company's own assets, or do they only permit competitive activities involving outside business interests?
In Pappas, JHO Gammerman chose the former interpretation based on Section 11's broad reference to "business ventures and investments of any nature whatsoever" (emphasis added). He also cited this language in distinguishing Continental Ins. Co. v. Rutledge & Co., 750 A2d 1219 (Del. Ch. 2000), where the court ruled that alleged self-dealing within the partnership was not insulated by the partnership agreement's provision permitting partners to engage "in other business activities of every kind and description" (emphasis added). JHO Gammerman also was careful to note that, although Section 11 is entitled "Other Activities of Members" (emphasis added), Section 20.7 of the operating agreement stated that "[t]he headings in this Agreement . . . shall be given no effect in the interpretation of this Agreement."
Last year, in Bay Center Apartments Owner, LLC v. Emery Bay PKI, LLC, No. 3658-VCS (Del. Ch. Apr. 20, 2009), Vice Chancellor Leo Strine instructed that, absent contrary provision in the operating agreement, LLC members owe each other the traditional fiduciary duties owed by directors to a corporation, and that the intent to eliminate fiduciary duty in the operating agreement must be made "plain and unambiguous." Does Section 11 meet that test? Is it material that Section 11 speaks of no "obligation" without expressly referring to waiver of fiduciary duty? Is the duty to disclose recognized in Blue Chip Emerald coterminus with the duty not to compete eliminated by Section 11? We'll have to wait and see if the losing side in Pappas takes an appeal. In the meantime, anyone drafting such a provision in a partnership, shareholders or operating agreement would be well advised to include the words "other business activities" in the body of any provision permitting competition by the owners.
Ribstein on Pappas: Read here Professor Larry Ribstein's cogent analysis of Pappas.
Update April 25, 2010: Plaintiffs in Pappas filed a notice of appeal on April 1, 2010. We'll have to wait and see if they perfect their appeal.
Update September 19, 2011: The case has taken a radical turn in favor of the plaintiffs. Last week, the Appellate Division, First Department, reversed JHO Gammerman's decision and reinstated the fiduciary breach and fraud claims. Read here my post on the appellate decision.
Tzolis No Solace for Proponent of LLC Member Expulsion
Two cases do not a trend make, but I can't shake the feeling that the Brooklyn-based Second Department appeals court has clamped down on the era of freewheeling judicial remedies in business breakup cases involving limited liability companies.
As I reported here, last January the Second Department issued a major ruling in the 1545 Ocean Avenue case articulating a new, tougher standard for LLC dissolution, in line with the Delaware approach, in which freedom of contract and fidelity to the operating agreement are paramount. Earlier this month, the Second Department issued another significant ruling in Chiu v. Chiu, 2010 NY Slip Op 01768 (2d Dept Mar. 2, 2010), holding that courts have no statutory authority to order expulsion of an LLC member for alleged misconduct, absent language in the operating agreement expressly providing for an expulsion remedy. In so ruling, the court turned its back on the appellant's argument that judicial expulsion should be recognized as a common law remedy under the reasoning of the Court of Appeals' 2008 decision in Tzolis v. Wolff, 10 NY3d 100, where it divined a common law basis for LLC derivative actions.
Chiu arises from a bitter family dispute between older brother Winston Chiu (WC) and younger brother Man Choi Chiu (MCC) featuring multiple lawsuits over a real estate holding limited liability company called 42-52 Northern Blvd., LLC formed in 1999. The property was purchased for approximately $5.5 million. The LLC had no written operating agreement. The LLC's 1999 and 2000 tax returns identified WC and MCC as holding 25% and 75% interests, respectively. Under a 1999 agreement, WC had certain rights to purchase the 75% interest held by his brother.
After disputes erupted, in 2001 WC unilaterally prepared a deed transferring the LLC's real property to his personal trust. In 2002, MCC sued WC and the trust to set aside the conveyance as fraudulent. After a trial the court entered judgment in MCC's favor voiding the property transfer and also declaring that WC was "never a member" of the LLC and that MCC was its "sole member". On WC's subsequent appeal, the Second Department issued a ruling in 2007 (reported at 38 AD3d 619) upholding the avoidance of the property transfer but reversing the judgment's negation of WC's membership interest in the LLC based largely on the tax returns.
MCC then started another lawsuit against WC asserting two claims: first, seeking a declaration of the brothers' respective ownership rights in the LLC and an accounting by WC in the event WC is determined to have an interest, and second, seeking a judgment removing WC as a member of the LLC based upon his alleged misconduct and breach of fiduciary duty surrounding the previously adjudicated fraudulent conveyance.
By decision and order dated March 11, 2008, Queens County Supreme Court Justice James P. Dollard partially dismissed MCC's first claim, insofar as it sought to characterize WC's interest in the LLC as "nominal," on res judicata and collateral estoppel grounds stemming from the Second Department's 2007 ruling. Of more interest, Justice Dollard granted WC's request to dismiss the second claim seeking his expulsion from the LLC, holding that the LLC Law does not authorize judicial removal of a member absent provision for removal in the operating agreement.
In between the submission of WC's dismissal motion and Justice Dollard's decision, the New York Court of Appeals (the state's highest court) decided the Tzolis case by 4-3 vote in favor of an LLC member's common-law right to bring derivative claims notwithstanding the legislature's deliberate omission of a statutory right of derivative action. In June 2008, MCC moved for reconsideration of the order dismissing his claim to expel WC, arguing that Tzolis represented a change in the law authorizing the court to devise an expulsion remedy for member misconduct even absent express statutory authority.
By order dated July 7, 2008, Justice Dollard denied MCC's motion, writing that the Tzolis majority relied on
the long common law history of derivative actions . . . but in the case at bar, plaintiff MCC did not show that there is a common law basis for the expulsion of a member of a limited liability company or even for the expulsion of a partner [in a partnership].
MCC thereafter appealed from the dismissal of his claim seeking to expel WC. MCC's brief on appeal (read here) raised two arguments. First, he rested judicial authority to grant the expulsion remedy on §701 of the LLC Law which expressly references the "expulsion" of a member (amongst other events including bankruptcy, death, dissolution, incapacity and withdrawal) as triggering the non-judicial dissolution of the LLC unless the remaining members authorize its continuation. (The statute was "flipped" by legislative amendment effective after the formation of the subject LLC, to provide for continuation of the LLC following such events unless the remaining members vote to dissolve.)
MCC devoted the greater part of his brief to his second argument based on Tzolis. Essentially, MCC argued that under Tzolis the courts have broad common-law authority to devise any and all equitable remedies for the misconduct of faithless fiduciaries, including expulsion of a member, unless affirmatively barred by the legislature. In other words, because Tzolis was based, in part, on the "absence of any expressed intent on the part of the Legislature to bar [derivative] actions in the context of limited liability companies" (Br. 29) and, in other part, on the court's recognition of "the importance of courts providing a judicial remedy for a breach of fiduciary duty" (Br. 26),
under Tzolis, a limited liability company must, and does, have the right to expel a dishonest and disloyal member, even in the absence of an operating agreement provision expressly providing for expulsion, lest the courts sanction or condone a "license to steal". [Br. 29]
WC's brief opposing the appeal (read here) argued that §701's single reference to expulsion does not authorize judicial expulsion and "simply means that in the event an operating agreement provides for such expulsion, certain events might thereafter occur if a member is actually expelled pursuant to agreement" (Br. 34). In response to the Tzolis argument, WC argued:
The Court in Tzolis merely stated that given the well established history of derivative suits, that particular remedy should be available to LLC members. It never stated that a fortiori other remedies that are not provided for in the LLC Act should be available. [Br. 36]
In his reply brief (read here), MCC pressed his argument for expansive judicial common-law authority to devise equitable remedies to right alleged wrongs, urging the court to apply the reasoning of Tzolis in support of an expulsion remedy for LLC member misconduct. His reply brief also cited Gottlieb v. Northriver Trading Co., LLC, 58 AD3d 550 (1st Dept 2009), which I wrote about here, where a Manhattan appellate panel relied on Tzolis in recognizing an LLC member's common-law right to an equitable accounting.
The Second Department's decision earlier this month, rejecting MCC's appeal, unfortunately does not directly address the Tzolis argument. According to attorney Jeffrey Eilender of Schlam Stone & Dolan LLP, who represented WC and attended the oral argument of the appeal, the panel gave the Tzolis argument a "very frosty" reception. In any event, here's what the court wrote:
The Supreme Court properly granted that branch of the defendant's motion which was to dismiss the second cause of action seeking his expulsion as a member of the plaintiff 45-52 Northern Blvd, LLC (hereinafter the LLC). It is undisputed that the default provisions of the Limited Liability Company Law apply, as neither the articles of organization nor the alleged operating agreement of the LLC contain a provision concerning expulsion of members (see Manitaras v Beusman, 56 AD3d 735; Ross v Nelson, 54 AD3d 258). Although Limited Liability Company Law § 701 mentions expulsion of members, there is no statutory provision authorizing the courts to impose such a remedy. Rather, the reference to expulsion of members contemplates the inclusion of such a provision in an operating agreement. As the LLC did not have an operating agreement setting forth a mechanism for the expulsion of members, the plaintiff failed to state a cause of action for this relief.
In a post I wrote over two years ago, spurred by a Utah court decision, I contrasted that state's LLC Act, which contains express authorization for judicial expulsion of an LLC member whether or not also authorized in the operating agreement, with New York's LLC Law which has no similar language. The Chiu decision removes any remaining doubt that the sole path to member expulsion for a New York LLC runs through the operating agreement. Does Chiu, on the heels of 1545 Ocean Avenue, also signal a pullback from liberal judicial intervention in the internal affairs of LLC members, effectively forcing the members to live with their agreements for better or worse? My safe answer is, it's too early to say.
Finally, the question whether it makes good sense to include a member expulsion clause in the operating agreement is an altogether different issue which, coincidentally, I raised in a post last month about a case in which the court upheld an LLC member's expulsion for cause as specified in the operating agreement.
Ribstein on Tzolis: Professor Larry Ribstein, no fan of the Tzolis decision, comments on Chiu here.
Court Adds Accounting Remedy to LLC Members' Arsenal
A year ago, in Tzolis v. Wolff, 10 NY3d 100 (2008), New York's highest court recognized the common law right of LLC members to bring a derivative action on the LLC's behalf. Late last month, in Gottlieb v. Northriver Trading Co., LLC, 58 AD3d 550 (1st Dept 2009), an intermediate appellate court cited Tzolis in support of its decision recognizing the right of LLC members to seek an equitable accounting under common law.
The "equitable action on account" has a rich legal history in early English and American law, reflecting a time when forms of pleading and the scope of judicial powers made sharp distinctions between actions "at law" and those "in equity." In modern usage, the accounting action allows a trust beneficiary, partner, etc. to compel a fiduciary entrusted with property to render an account of his or her actions and for the recovery of any balance found to be due. The accounting involves more than simply turning over existing financial records. In New York practice, if the court grants an accounting, it may order the fiduciary to prepare a "long accounting" with detailed schedules of income and expenses over a defined period, followed by the filing of objections to the accounting, followed by proceedings before a court-appointed referee to hear and determine the accounting. (To view a form of order of reference to determine an account, click here.)
In the partnership setting, the partner's common law right to an equitable accounting also is codified in New York's Partnership Law Section 44 (derived from Section 22 of the Uniform Partnership Act) stating that "any partner shall have the right to a formal account as to partnership affairs" under broadly defined circumstances. In the business corporation setting, Section 720 of the Business Corporation Law authorizes a shareholder's derivative action against directors or officers to compel an accounting.
New York's LLC Law contains no provision authorizing a judicial accounting remedy. The Gottlieb case appears to be the first one to address the availability of an equitable accounting remedy in the LLC setting.
According to plaintiff Helene Gottlieb's complaint, Northriver Trading Co., LLC was in the securities trading business from 1994 through 2000. She initially held a 50% interest reduced to 20.6% in 1999. Defendant Steven Schlam is the managing member. The complaint alleges that at the time it ceased doing business, Northriver "had substantial assets, the precise value of which is unknown to plaintiff, but upon information and belief, exceeded $2,000,000."
Gottlieb alleges that, beginning in 2001, she unsuccessfully sought an accounting of Northriver's financial affairs and the "net amount due plaintiff"; that the defendants "wrongfully failed and refused" to provide her with the requested accounting; and that they imposed "onerous and unreasonable preconditions on an accounting, beyond the means of [Gottlieb] to satisfy, such as the requirement that any accounting must be conducted by an accountant approved in advance by defendants."
The single-count complaint alleges that Gottlieb "has no adequate remedy at law" and demands a judgment
compelling defendants [Northriver and Schlam] to provide plaintiff with a full and complete accounting of the financial affairs of defendant [Northriver] including but not limited to income and expenses, profits and losses, overpayment of trading commissions, the amount of accounts receivable and efforts being made to collect the same, and the net amount due to plaintiff.
The defendants asked the trial court to dismiss the complaint. They argued that Northriver provided Gottlieb with all documents pertaining to its finances -- including balance sheets, income statements, tax returns, bank statements, canceled checks, vendor invoices, correspondence, detailed brokerage statements and work papers -- and thereby satisfied its obligations under Section 1102 of the LLC Law to provide member access to company records. (The decision does not indicate whether the information was given to Gottlieb pre-litigation or post-litigation in discovery.)
In a decision dated May 9, 2007, written by New York County Supreme Court Justice Jane S. Solomon, the trial court agreed with the defendants and dismissed the complaint. The court found that Northriver "has provided all of the documents that it is required to provide" under LLC Law Section 1102. It further held that the "plaintiff is not entitled to an accounting merely by virtue of her status as a member of the limited liability company" and that "there is nothing in the LLC Law to suggest otherwise." The court distinguished Gottlieb's case authorities "because they do not involve limited liability companies."
On appeal, Gottlieb won a reversal. Devoting all of three sentences to the issue, the Appellate Division, First Department wrote as follows:
Contrary to the court's ruling, members of a limited liability company may seek an equitable accounting under common law. The assertion that such members are limited to statutory remedies with regard to potential fraud is inconsistent with the reasoning in Tzolis v Wolff (10 NY3d 100 [2008]). Furthermore, while plaintiff's sole claim was for an accounting, the ad damnum of her complaint did seek monetary damages based on misallocation of the company's assets, and the case should thus be permitted to go forward.
In Tzolis, by a vote of 4-3, the Court of Appeals ruled that the legislature's deliberate omission from the LLC Law of proposed language authorizing derivative actions by LLC members did not preclude the courts from finding a right to bring derivative claims under common law. Whether one agrees or disagrees with Tzolis, it's hard to quarrel with the First Department's implied prediction that the Court of Appeals likely would apply similar reasoning to uphold an LLC member's common law right to an accounting.
Gottlieb can be viewed as another step toward New York's judicial homogenization of the closely held business entity, in which court-imposed fiduciary obligations and common law remedies are imported and spread evenly across partnerships, business corporations and now limited liability companies. For better or worse, this is in sharp contrast to the emerging Delaware model in which LLCs are "creatures of contract" and the courts are loathe to impose duties or create remedies outside the four corners of the members' operating agreement.
For Professor Larry Ribstein's decidedly negative take on Gottlieb, see here. For a spirited defense of Gottlieb, read the below comment by the attorney who argued the appeal.
