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.