On November 15, 2011, the spectacular Albany courtroom pictured at left was the setting for oral argument before the New York Court of Appeals in Roni LLC v. Arfa, No. 228, in which the court is poised to decide whether pre-formation limited liability company “promoters” have a fiduciary duty of disclosure to potential investors. The outcome could have a significant impact on investment structure and investor solicitation, especially in the real estate industry where the LLC, for tax and other reasons, is the preferred form of business organization.

The case involves claims by a group of Israeli real estate investors who purchased membership interests in a series of LLCs formed to acquire, renovate, manage and eventually re-sell multi-family residential properties in New York City. The complaint’s gravamen is that the defendants, who identified the properties, solicited investors, organized the LLCs, negotiated the acquisitions and obtained mortgage financing, concealed from the plaintiffs certain “brokerage” fees of up to 15% that the defendants were to receive from the property sellers and mortgage brokers, eventually exceeding $6.5 million. The plaintiffs alleged that the defendants as “promoters” of the to-be-formed LLCs had a fiduciary duty to disclose the brokerage arrangement to the plaintiffs as prospective investors, and that the fees inflated the purchase prices paid for the properties to plaintiffs’ financial detriment.

The trial court denied defendants’ motion to dismiss the complaint. In a June 2010 decision which I reported on here, the intermediate appellate court held that the complaint’s allegations did not state a traditional claim for breach of fiduciary duty based on a business or personal relationship of trust and confidence, superior expertise and knowledge. The court nonetheless upheld the denial of the defendants’ dismissal motion based on the defendants’ “status as the organizers of the business venture”, explaining as follows:

[P]laintiffs’ 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. It is well settled that both before and after a corporation comes into existence, its promoter acts as the fiduciary of that corporation and its present and anticipated shareholders. By extension, the organizer of a 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. Accordingly, plaintiffs stated a cause of action for breach of fiduciary duty by alleging that the promoter defendants failed to reveal that they would receive commissions from sellers and mortgage brokers in addition to their other, disclosed, profit from the venture. [Citations omitted.]

The Briefs

In September 2010, the intermediate appellate court granted the defendants’ motion for leave to appeal to the state’s highest court, the New York Court of Appeals.

The defendants’ brief filed in the Court of Appeals (read here) argues:

• the 19th century case authorities relied on by the lower court, involving promoters of corporations, did not establish a per se rule that promoters were fiduciaries as a matter of law;
• those authorities require a relationship of trust and confidence which the lower court expressly found lacking in Roni; and
• even if the old authorities did create a status-based rule for corporation promoters, it should not be applied to persons who organize LLCs.

The last point contrasts the discretion and control exercised by corporation organizers in creating the initial governance structures (i.e., articles of incorporation and bylaws) and deciding how to use investor money, with the contract-based LLC form in which governance and capital structures are set forth in written, fully integrated operating agreements executed by the investors.

The plaintiffs’ opposing brief (read here) argues:

• the defendants’ control of the investors’ funds and management of the enterprise in the period prior to formation of the LLCs give rise to a fiduciary duty of disclosure of “hidden commissions”;
• the common law rules governing corporation promoters as a matter of legal theory and policy should extend to LLC promoters; and
• in the alternative, the intermediate appellate court erred in holding that the complaint failed to allege a fiduciary relationship based on the defendants’ special knowledge and real estate expertise coupled with the defendants’ solicitation of overseas investors through personal relationships and “cultural affinity”.

Professor Larry Ribstein, a leading authority on LLC and partnership law, filed an amicus brief in support of the defendants’ position (read here), in which he argues:

• the intermediate appellate court’s holding in favor of fiduciary duty of disclosure of organizers of LLCs is unprecedented in the law of LLCs;
• the NY LLC Law’s provisions governing organizers and managers do not support a status-based fiduciary obligation for the former; and
• the old corporate promoter cases, even if not made “dead letter” by federal and state securities laws, should not be applied to establish pre-formation duties in LLCs, among other reasons, because unlike corporations, LLCs are “creatures of contract” that do not present “a potential for abuse comparable to that of large business entities seeking capital from hundreds or thousands of small investors.”

The Oral Argument

If you click here, you can view a video webcast of the oral argument in Roni held on November 15, 2011. But first, you’ll need some navigational aid.

The Court of Appeals combined oral argument in Roni with a second case, Assured Guaranty (UK) Ltd. v. J.P. Morgan Investment Management Inc., No. 227, due to the circumstance that both cases raise issues involving a preemption defense under the anti-fraud provisions of New York’s Martin Act governing the sale of publicly offered securities. The entire argument lasts an hour. If you’d like to view the Roni portion of the webcast, click on the first entry on the November 15 calendar and, once the video opens, advance to the 27 minute mark for argument by defendants’ counsel immediately followed by plaintiffs’ counsel until the 45 minute mark. Defendants’ counsel’s rebuttal argument picks up at the 58 minute mark and goes just a few minutes to the end of the session. In the summary that follows, numbers in parentheses refer to the minute and second marks in the video.

Four of the six judges who heard the argument (Judge Smith recused himself) questioned the attorneys in Roni, with Chief Judge Lippman being the most active inquisitor. Early in defense counsel’s argument (28:20), Judge Lippman set a somewhat skeptical tone with the questions, “What is the fact that it’s an LLC have to do with the fiduciary duty issue?” and “Why should LLCs be treated differently?” to which defense counsel answered, LLCs are based on contractual relations established by the parties in the operating agreement and, therefore, at the pre-formation stage there is no point at which one can say the fiduciary relationship begins and ends.

Judge Graffeo queried (29:15) if the intermediate appellate court “went too far” in drawing such a close comparison between the corporate realm and LLCs, with which defense counsel readily agreed, stating that absent allegations of a relationship of trust and confidence, superior skill and knowledge, there can be no fiduciary obligation imposed on a promoter of a corporation or an LLC, and if there’s no fiduciary relationship, the promoter has no duty to disclose a pre-formation commission arrangement like the one in Roni.

Judges Graffeo (31:50) and Pigott (32:40) asked several questions focused on the adequacy of the complaint, and whether the plaintiffs in Roni sufficiently alleged for pleading purposes a fiduciary relationship based on the plaintiffs’ foreign residence and their dependence on the real estate expertise of the defendants, to which defense counsel replied that, in an interlocutory appeal (as opposed to an appeal from a final judgment), the Court of Appeals lacks jurisdiction to review the intermediate appellate court’s ruling that the complaint fails to plead the traditional badges of a fiduciary relationship.

Plaintiffs’ counsel was met by questions from Judge Lippman (35:05) as to the basis for the alleged fiduciary relationship and if it matters “whether you’re an LLC or not?” Plaintiffs’ counsel replied that the business form does not matter (“not at the starting gate yet”) and that the “control and domination” exercised by defendants over the pre-formation enterprise imposes fiduciary duties of disclosure.

Judge Ciparick asked (37:20) whether the purchase prices of the real properties were inflated by the secret commissions, to which plaintiffs’ counsel answered “Yes, absolutely” and that the plaintiffs consequently suffered a direct, out-of-pocket loss.

Judge Graffeo then asked (39:30) whether an undisclosed commission, standing alone, creates a fiduciary relationship and, if other factors must be pleaded, whether the Court of Appeals has jurisdiction to review the finding below that the complaint did not adequately allege the traditional fiduciary badges. Plaintiffs’ counsel responded that a claim based on undisclosed commission is stated where the promoters solicited investors, controlled the funds and controlled the properties, and that the Court of Appeals has jurisdiction to affirm the decision below on an alternative ground.

Judge Pigott next asked (41:50), “Is there any limit to this?” and “Can you bring a case similar to this on almost any set of facts in which someone is dissatisfied with the amount of the return they got?” Plaintiffs’ counsel suggested in reply that such cases are limited to ones where the promoter sells the investment, controls the investment funds pre-formation, and where the alleged non-disclosure — here, the $6.5 million in commissions — is material to the decision to invest.

Judge Pigott then pressed counsel (43:25) to identify the source of the alleged fiduciary duty in Roni, to which plaintiffs’ counsel replied that it stems from the defendant promoters’ soliciting the investment, taking the investors’ money, controlling the expenditure of the monies, hiring counsel for the enterprise, arranging financing for the acquisitions, and managing the properties, to which Judge Pigott responded (44:00), “That’s kind of where I’m looking for the line drawing because if you have a situation where each one of those is a fiduciary obligation, each one could be a cause of action for breach of fiduciary duty.”

In his rebuttal argument (58:00), defendants’ counsel contended that his clients did not exercise control and domination over the investments, and that they were required to use investor funds in the manner specified in the written promotional materials provided to the plaintiffs. Judge Lippman asked (59:25), “What about the concealment of the 15% fee?” to which defendants’ counsel replied that the defendants were not disputing concealment for purposes of the dismissal motion but that, without an independent basis for imposing a fiduciary duty, the concealed fees could not give rise to liability.

Will New York be the first state to adopt a status-based rule holding LLC promoters to a fiduciary standard? If not, will the Court of Appeals nonetheless affirm on the ground that the complaint adequately pleads a fiduciary relationship based on control and domination or, contrariwise, will it dismiss the fiduciary breach claim on the basis it has no jurisdiction to review the intermediate appellate court’s conclusion that the complaint does not plead a fiduciary relationship other than based on the defendants’ status as promoters?

We’ll likely have to wait until the early months of next year for the answer, though that may also depend on how long the Court takes to decide the related appeal in the Assured Guaranty case. Indeed, if the Court in that case and in Roni holds that the Martin Act preempts the plaintiffs’ common law claims, the LLC promoter liability issue in Roni likely will be mooted.