The question posed by this post’s title derives from an unpublished decision earlier this month in a case called Pappas v. Tzolis, Mem.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.