The basic storyline is familiar: Controlling owner of closely held company buys out interests of non-controlling owners who subsequently sue for breach of fiduciary duty and fraud after learning that the controlling owner soon thereafter sold the company or its assets to a third party at a much higher price, or that the company assets have a much higher valuation than previously represented.
The most prominent, recent cases of this kind, such as Blue Chip Emerald v. Allied Partners, Littman v. Magee and Centro Empresarial Cempresa v. America Movil, have focused primarily on the efficacy or not of releases and disclaimers in the buyout contracts, raised as defenses by the purchasing owner faction. New York’s highest court, the Court of Appeals, likely will shed some additional light on the interplay of release and the fiduciary duty of disclosure when it issues its ruling in the Centro Empresarial case in the next month or so.
Meanwhile, the Appellate Division, First Department, last month handed down a notable decision in Frame v. Maynard, 2011 NY Slip Op 03335 (1st Dept April 28, 2011) (recalling and vacating the court’s decision and order entered on November 18, 2010, reported at 78 AD3d 508), stemming from a suit against the general partner of a real estate limited partnership who misled the limited partners into selling him their interests at a price far below market value. The decision is of interest primarily because it directs an award of Rothko damages — named after the New York Court of Appeals’ decision in Matter of Rothko, 43 NY2d 305 (1977) — calculated as the difference between the actual sale price and the value of the asset or interest at the time of the trial as opposed to the time of the transaction at issue. In Frame, the subject realty appreciated greatly between the conveyance of the limited partner interests in 2002 and the trial over five years later.
I can’t improve on the summary of the facts in the appellate court’s decision, so here it is:
Plaintiff Frame and defendant Maynard were the two general partners of a limited partnership (the Partnership), formed in 1980, to acquire and operate a building at 5008 Broadway, and they acquired the underlying land as tenants in common. The eight limited partnership shares were acquired by Maynard, Guthrie, Paulson, Hines and others. Under the limited partnership agreement (the Agreement), the net proceeds of a sale or refinancing of the “Project,” defined as the building, were to be split 60-40 between the limited partners and the general partners. Following a settlement agreement entered into in 1986, Frame conveyed his half-interest in the underlying land to the Partnership and resigned as general partner. The Agreement was amended to provide that Frame would receive 20% of the net proceeds of a sale or refinancing of the “real property in the Project,” with the remainder to be split 25% to the general partner and 75% to the limited partners.
In May 2001, Maynard offered to acquire the limited partners’ interest in the Partnership property for $842,427. Maynard provided schedules to the limited partners representing that the value of the building, based on its cash flow as shown in historical profit and loss statements, was $665,074 or $842,427, depending on the capitalization rate used. A majority of the limited partners consented to Maynard’s proposed acquisition of the property, i.e., the building and the 50% ownership interest in the land owned by the partnership, on his own behalf or for a wholly owned entity.
However, Maynard did not disclose to the limited partners that, since March 2001, he had been negotiating with the Community Preservation Corporation (CPC) to obtain a mortgage loan on the property at 5008 Broadway from the Federal Home Loan Mortgage Corporation (Freddie Mac) in the proposed amount of $1,550,000. During those negotiations, Maynard provided CPC with “adjusted” historical profit and loss numbers, which supported the proposed loan amount. An appraisal prepared by an independent appraiser in connection with Maynard’s loan application valued the building and land in the range of $2.2 million as of June 2001. In November 2001, Maynard sent checks in the amount of about $40,000 per share to the limited partners purportedly representing their share of the sale of the Partnership property.
On February 7, 2002, Maynard assigned his right to acquire the Partnership property to defendant 5008 Broadway Associates, LLC (5008 LLC) for nominal consideration, and a deed conveying the property to 5008 LLC was filed. On the same date, 5008 LLC received a mortgage loan from CPC in the amount of $1,485,000, leaving net proceeds of about $1 million. In late February, Maynard made an additional distribution to the limited partners of about $5,000 per share, purportedly representing final distribution of the Partnership’s assets.
In June 2004, after a title search disclosed the 2002 conveyance, the former general partner, Frame, filed a complaint seeking to recover his 20% share of the net proceeds under the amended 1986 agreement. Several limited partners asserted cross claims against Maynard for constructive fraud and breach of fiduciary duty based on his false representations to them of the realty’s value while failing to disclose the impending refinancing and $2.2 million June 2001 appraisal.
Following a 19-day bench trial before Manhattan Supreme Court Justice Paul G. Feinman, in October 2008 the court issued a 58-page Decision and Order After Trial and thereafter entered a judgment against Maynard. The judgment awarded Frame about $421,000 on his claim for breach of contract, representing 20% of the deemed net proceeds using a $2.9 million appraisal as of February 2002. The judgment also awarded two of the limited partners, on their claims for breach of fiduciary duty, amounts equal to the differential between what they received for their limited partner interests and the deemed value of their interests also based on the $2.9 million February 2002 appraisal.
The court’s calculation of the limited partner awards excluded Maynard’s one-eighth limited partner interest. All amounts awarded carried pre-judgment interest at 9% from February 2002.
The court’s decision and the judgment also dismissed the claims of one limited partner, Hines, whom the court considered to be a “sophisticated investor who could have rather easily made further inquiry into the likelihood of the property value as represented by Maynard prior to consenting to the transaction” (Decision and Order, pp. 40-41).
Appeals and cross appeals followed as to liability and damages. In its decision, the appellate court notes its deference to the trial court’s finding that Maynard “was not a credible witness,” and it concludes that Maynard’s denial of knowledge of the $2.2 million June 2001 appraisal was “at odds with common sense.” The court also affirms the trial court’s finding that Maynard breached his duty of “undivided and undiluted loyalty” by failing to inform the limited partners of his negotiation of a $1.5 million mortgage loan and concomitant valuation over $2 million. The limited partners, including Hines, justifiably relied on Maynard’s misrepresentations of the realty’s value. The appellate court also upheld the trial court’s finding that Maynard breached Frame’s contractual entitlement by failing to pay his 20% share of the sale proceeds.
The court’s discussion of Rothko damages begins with a statement of the general rule for measuring damages when a fiduciary has sold property for an inadequate price, i.e., the difference between what was received and what should have been received, “so that the beneficiary of the fiduciary duty is placed in the same position he or she would have been in absent the breach.” Rothko, however, created an exception to the general rule “where the breach of trust consists of a serious conflict of interest — which is more than merely selling for too little.” Thus, when a fiduciary engages in self-dealing, under Rothko the court can use an increased measure of damages based on the value of the subject asset at the time of the trial.
Obviously, the Rothko rule can greatly augment a plaintiff’s damage award when the asset being valued appreciates at a rate higher than the pre-judgment interest rate (9%) between the transaction date and the time of trial which usually takes places many years later. In Frame, the trial court’s Decision and Order refers to testimony by an appraisal expert called on behalf of one of the limited partners, stating that the estimated value of the realty in 2007, when the trial began, was $7.5 million or about two and a half times its value in February 2002.
The appellate court finds Rothko and the circumstances in Frame indistinguishable:
In both cases, the trial court found a breach of fiduciary duty as well as both constructive and actual fraud resulting from self-dealing by the fiduciaries. The Rothko Court described the conduct of the estate trustees as “manifestly wrongful and indeed shocking” (Rothko, 43 NY2d at 314). Maynard’s conduct in the present case is no less improper, especially given that he repeatedly assured the limited partners that the price he was offering was generous while simultaneously negotiating for a mortgage that presupposed a far higher valuation for the Partnership property.
The appellate court nonetheless hands Maynard a small victory by holding improper the trial court’s determination to exclude Maynard’s limited partnership share from the calculation of the limited partners’ damages. Since Maynard did not acquire his interest as a result of fraud or breach of duty, disregarding his share in calculating damages “leads to an unwarranted windfall” for the other limited partners.
The decision remands the case for further proceedings on damages in accordance with the opinion. By Order dated May 18, 2011, the trial court ordered an exchange of expert reports and set the matter down for a hearing on Rothko damages on July 7, 2011. If, as one expert already testified, the court determines that the realty had a $7.5 million value as of 2007 when the trial commenced, the damages due the limited partners by Maynard likely will increase twofold or more.
Update June 25, 2013: After a hearing, the trial judge awarded Frame appreciation damages of $483,593 per partnership unit plus interest from October 2008. Maynard appealed. By order dated June 25, 2013 (read here), the Appellate Division, First Department, reduced the award to $414,921 per unit and otherwise affirmed the lower court’s order.