In the clash between the “punctilio of an honor the most sensitive” and the “morals of the marketplace” (Benjamin Cardozo in Meinhard v. Salmon), marketplace beat out punctilio.
That’s one way to think about last week’s important rulings by New York’s highest appellate court in two cases testing the efficacy of releases as a defense against fraudulent inducement claims in litigation between co-owners and fiduciaries of closely held businesses. Another way to think about it: New York judges will not substitute their ex post judgment based on fluid notions of equity and fairness for contractual undertakings freely arrived at through arm’s-length bargaining between sophisticated business partners.
In Centro Empresarial Cempresa S.A. v. America Movil, S.A.B. de C.V., 2011 NY Slip Op 04720 (Ct. App. June 7, 2011), the Court of Appeals affirmed the intermediate appellate court’s dismissal of a lawsuit by minority owners of a privately-held telecommunications company, in which they alleged breach of fiduciary duty and fraud by the majority owner in connection with the buy-out of their equity interests, based on a written release given as part of the buy-out agreement. In Arfa v. Zamir, 2011 NY Slip Op 04719 (Ct. App. June 7, 2011), the Court of Appeals likewise held that a release provision in a co-management agreement between co-owners of a realty company required dismissal of breach of fiduciary duty and fraud claims based on alleged non-disclosure of major problems with a property acquisition.
In both cases, the trial courts had permitted the lawsuits to go forward citing case law from the Manhattan-based Appellate Division, First Department, seemingly indicating that a fiduciary involved in a self-interested transaction with another owner can almost never rely on a release to avoid liability against allegations of non-disclosure and fraudulent inducement. That broad proposition is dead after Centro and Arfa.
Centro, the more important of the two decisions, involves a Delaware LLC that owned an Ecuadorian telecommunications company known as Conecel. A company called Telmex, owned by Mexican billionaire Carlos Slim, held a 60% controlling interest in Conecel. In 2000, the plaintiffs, who held the other 40%, entered into various agreements with Telmex, among other things, giving plaintiffs the right to put their stake to Telmex at a fixed price based on a 1999 valuation.
Plaintiffs alleged that Telmex subsequently dodged their requests for financial information and otherwise falsely painted a bleak picture of Conecel’s finances, causing plaintiffs in 2002 to exercise put rights for half their stake for $64 million. In 2003, after Telmex allegedly continued to obfuscate and provide misleading financial disclosure, Telmex offered to purchase plaintiffs’ remaining stake for another $64 million. Plaintiffs accepted. The 2003 purchase agreement included a broad general release in Telmex’s favor of all claims relating to plaintiffs’ membership interests in Conecel.
In 2008, after a government audit allegedly disclosed that Conecel’s financial condition in 2001-03 was significantly better than represented by Telmex, the plaintiffs sued Mr. Slim and his companies for breach of fiduciary duty and fraudulent inducement, claiming that had they known Conecel’s true condition, instead of selling their shares they would have exercised certain exchange rights that would have given them shares in a roll-up entity worth over $1 billion in 2008.
The trial court denied defendants’ motion to dismiss the suit based on the general release. Defendants appealed to the Appellate Division, First Department which, by 3-2 vote in a June 2010 decision, reversed the lower court and dismissed the complaint. (Read here my post about the First Department’s ruling.) Plaintiffs then appealed to the New York Court of Appeals.
Following oral argument last April (watch it here), the Court of Appeals last week unanimously affirmed the First Department majority’s ruling. In a unanimous decision written by Judge Carmen Ciparick, the court starts its analysis by stating the general rule, that a valid release constitutes a complete bar to an action on a claim which is the subject of the release, and that “a party that releases a fraud claim may later challenge that release as fraudulently induced only if it can identify a separate fraud from the subject of the release.” The alleged fraudulent conduct in Centro, the court finds,
falls squarely within the scope of the release: plaintiffs allege that defendants supplied them with false financial information regarding the value of [Conecel] and that, based on this false information, plaintiffs sold their interests in [Conecel] and released defendants from claims in connection with that sale. Thus, as the Appellate Division observed: “plaintiffs seek to convert the 2003 release into a starting point for new . . . litigation, essentially asking to be relieved of the release on the ground that they did not realize the true value of the claims they were giving up.”
The court then addresses the core issue: does the defendants’ status as a fiduciary, standing alone, change the equation? Prior decisions of the First Department, exemplified most famously by Littman v. Magee, 54 AD3d 14 (2008), and Blue Chip Emerald v. Allied Partners, Inc., 299 AD2d 278 (2002), strongly suggested a “yes” answer, seemingly holding that the controlling owner involved in a transaction with another owner owes a non-releaseable fiduciary duty to disclose to the co-owner all material information bearing on the transaction. (Read here my post on Littman.) The Court of Appeals gives a definitive “no” answer, albeit with certain caveats, and in so doing explicitly disagrees with Littman et al. States the court:
A sophisticated principal is able to release its fiduciary from claims — at least where, as here, the fiduciary relationship is no longer one of unquestioning trust — so long as the principal understands that the fiduciary is acting in its own interest and the release is knowingly entered into (see Alleghany Corp., 333 F2d at 333 [“There is no prerequisite to the settlement of a fraud case that the (fiduciary) defendant must come forward and confess to all his wrongful acts in connection with the subject matter”]; Consorcio Prodipe, S.A. de C.V., 544 F Supp 2d at 191). To the extent that Appellate Division decisions such as Littman v Magee (54 AD3d 14, 17 [1st Dept 2008], Blue Chip Emerald v Allied Partners Inc. (299 AD2d 278, 279-280 [1st Dept 2002]), and Collections v Kolber, 256 AD2d 240, 241 [1st Dept 1998]) suggest otherwise, they misapprehend our case law. Plaintiffs here are large corporations engaged in complex transactions in which they were advised by counsel. As sophisticated entities, they negotiated and executed an extraordinarily broad release with their eyes wide open. They cannot now invalidate that release by claiming ignorance of the depth of their fiduciary’s misconduct.
The court also emphasizes the plaintiffs’ failure adequately to allege justifiable reliance on the defendants’ fraudulent statements in executing the release:
Here, according to the facts alleged in the complaint, plaintiffs knew that defendants had not supplied them with the financial information necessary to properly value [Conecel], and that they were entitled to that information. Yet they chose to cash out their interests and release defendants from fraud claims without demanding either access to the information or assurances as to its accuracy in the form of representations and warranties. . ..
In certain circumstances, a fiduciary’s disclosure obligations might effectively operate like a written representation that no material facts are undisclosed, and this might satisfy a principal’s obligation to investigate further. Where a principal and fiduciary are sophisticated parties engaged in negotiations to terminate their relationship, however, the principal cannot blindly trust the fiduciary’s assertions. This is particularly true where, as alleged here, the principal has actual knowledge that its fiduciary is not being entirely forthright . . ..
Plaintiffs repeatedly and unsuccessfully attempted to hold defendants to their disclosure obligations for years before negotiating and executing the sale of their shares and the accompanying releases. Moreover, the complaint alleges that plaintiffs were driven to sell because they were “wary of the threat that defendants would never negotiate in good faith and would never distribute the Conecel profits.” Plaintiffs therefore cannot be said to have reasonably relied on defendants’ assertions regarding Conecel’s performance in executing the releases.
The 2003 release, the court concludes, “was intended to bar the very claims that plaintiffs now bring.” The plaintiffs, who released defendants “without conducting even minimal dilgence to determine the true value of what they were selling,” also “fail to allege that the release was induced by fraud beyond that contemplated by the release.”
I won’t linger on the court’s brief, unsigned opinion in Arfa v. Zamir in which the plaintiffs sued a co-member of a realty holding company for fraudulent inducement concerning an agreement that gave the defendant co-equal management authority, notwithstanding the agreement’s inclusion of a broad general release. The court affirms the First Department’s decision enforcing the release and dismissing the case, finding that the plaintiffs failed to allege that the release was induced by a separate fraud or that plaintiffs justifiably relied on defendant’s fraudulent misstatements in executing the release. In addition,
[b]y their own admission, plaintiffs, who are sophisticated parties, had ample indication prior to June 2005 that defendant was not trustworthy, yet they elected to release him from the very claims they now bring without investigating the extent of his alleged misconduct.
In my post three years ago I queried whether, after Littman, “business owners [can] 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.” With its explicit repudiation of the analysis used in Littman, the Court of Appeals in Centro and Arfa has reinvigorated the purpose and efficacy of negotiated releases in buy-outs and other agreements between co-owners/fiduciaries of closely held companies. The onus rests on the selling party to perform adequate diligence prior to completing the transaction, or otherwise bargaining for consideration commensurate with its chosen level of diligence. Be mindful, however, that Centro and Arfa both involved sophisticated business owners on both sides of the transactions with prior histories of strife and mistrust. Take away those elements and it still may be possible for a business owner to overcome a release given in connection with a buy-out or other agreement based on alleged failure by a fiduciary to disclose material information.
Update March 6, 2012: The Centro decision is prominently cited in a decision by the Delaware Chancery Court in Schonfeld Group Holdings, LLC v. Trillium Holdings, LLC, C.A. No. 6759-VCL (Del Ch Mar. 6, 2012), where, applying New York law, Vice Chancellor Laster dismissed fraudulent inducement and other claims based on a release given as part of an LLC membership redemption agreement. (HT Ed McNally)