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.