Section 409 of New York’s LLC Law provides that an LLC manager (which also includes a member-manager) “shall 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.” As I’ve previously written, § 409’s language is lifted almost verbatim from the standard for director conduct in § 717 of the Business Corporation Law, and the courts have construed both statutes as imposing traditional fiduciary duties of care and loyalty.

Section 409 also borrows from BCL § 717 its so-called safe harbor provisions that shield managers from liability when, in undertaking the challenged action, they rely in good faith on “information, opinions, reports or statements, including financial statements and other financial data” prepared or presented by agents and employees of the LLC or by outside legal and accounting professionals.

As far as I can tell, last week’s decision by the Manhattan-based Appellate Division, First Department in Pokoik v Pokoik, 2014 NY Slip Op 01502 [1st Dept Mar. 6, 2014], is the first New York appellate ruling to address a safe-harbor defense to a claim for breach of fiduciary duty by an LLC manager. The court’s unanimous opinion rejected the defense, which was based on the defendant manager’s claimed reliance on the advice of the LLC’s outside accountant, because the manager’s self-interested conduct and failure “to make truthful and complete disclosures” negated any showing of the manager’s good faith.

Various members of the Pokoik family have been at war for the last six years over a collection of Manhattan rental properties, some owned as tenancies in common and others held in limited liability companies. In 2006, Leon Pokoik agreed to yield management control to Gary Pokoik after Gary allegedly discovered that Leon had misappropriated large sums. In July 2006, they entered into a written agreement under which Leon reimbursed the companies $2.2 million–which was less than the amount at issue–and any “discrepancy” between payments recorded in the properties’ books and their bank statements would be “written off.”

The Lower Court’s Decision

In 2010, Leon sued Gary for breach of fiduciary duty for improperly reducing his capital accounts in the companies and reducing or failing to make required distributions based on the improper write-downs. Gary eventually moved for summary judgment, arguing that Leon’s capital accounts were reduced for the written-off funds resulting from Leon’s alleged misappropriations discovered in 2006, and that in doing so Gary followed the companies’ outside accountant’s advice and instruction to place the entire burden of the write-off on Leon.

Leon cross-moved for summary judgment in his favor, contending that the 2006 settlement agreement limited his responsibility for his alleged misappropriation to his $2.2 million repayment and that, consequently, the write-down of his capital accounts and commensurate reduction of distributions was improper and in bad faith.

The lower court, in a January 2013 decision by Manhattan Supreme Court Justice Joan M. Kenney (read here), denied summary judgment. The court found that the settlement agreement was “ambiguous in reference to the write down” and that “[t]he reasons for, and the appropriateness of the write down, the purported bad faith of Gary in determining to write down Leon’s capital accounts and the degree to which Gary relied upon [the accountant’s] advice are factual issues that are more properly resolved by a finder of fact at trial.”

The Appellate Court’s Decision

Both sides appealed from Justice Kenney’s decision. In its ruling last week, the First Department sided with Leon and ordered summary judgment in his favor on his claim against Gary for breach of fiduciary duty.

The court’s opinion acknowledges that, as the managing member of the LLCs, Gary owed Leon a fiduciary duty “‘of undivided and undiluted loyalty . . . barring not only blatant self-dealing, but also requiring avoidance of situations in which a fiduciary’s personal interest possibly conflicts with the interest of those owed a fiduciary duty'” (quoting Birnbaum v Birnbaum, 73 NY2d 461, 466 [1989]).

On the other hand, the court also acknowledges that under LLC Law § 409(b)(2)’s safe-harbor provision, as manager Gary is entitled to rely on the advice of outside professionals, so long as he does so “in good faith.” The court’s analysis of the record leads it to conclude that “Gary does not meet his initial burden of showing that he acted in good faith and undivided loyalty to plaintiff so as to rely on [LLC] Law § 409 . . ..”

The factors cited by the court include:

• Neither the 2006 settlement agreement nor the LLCs’ operating agreements provided any authority for Gary to unilaterally reduce Leon’s capital accounts.
• Gary failed to inform Leon of the accountant’s recommendation to write down Leon’s capital accounts, and failed to notify Leon that his capital accounts, and no one else’s, were depleted in order to address the tax situation.
• Gary had a personal interest in reducing Leon’s capital accounts, as opposed to charging the LLCs, because the latter option would ultimately have had a negative impact on Gary.
• Leon received distributions for about three years after his capital accounts were emptied. Said the court: “Gary’s lack of good faith is revealed when he does not explain why the terms of the operating agreement were disregarded for three years and then suddenly enforced.”
• In the 2006 settlement agreement, Gary released any claims against Leon based on Leon’s alleged misappropriations from the companies.

Summing up, the court wrote:

While it may be that Gary relied on his accountant’s opinion when he drained plaintiff’s capital account, his and the accountant’s failure to inform plaintiff of this decision or of the subsequent elimination of distributions, clearly establishes plaintiff’s claim that Gary was not acting in his best interest and that Gary breached his fiduciary duty of care.

Notably, nowhere in the court’s opinion does it pronounce as contrary to applicable tax code and regulations the treatment of Leon’s capital account recommended by the accountant. Rather, the court’s ruling concentrates on Gary’s failure to inform Leon of the discriminatory tax treatment, and Gary’s inconsistent application of the account write-downs for several years after the 2006 settlement. Those factors, when combined with Gary’s self-interest in writing down Leon’s capital accounts, satisfied the court that Gary’s reliance on the accountant’s advice did not meet the good faith standard as a matter of law.

The other lesson to be learned from Pokoik stems from the parties’ failure to deal with the issue in their 2006 settlement agreement insofar as Leon’s $2.2 million reimbursement was approximately $750,000 less than the “discrepancy” between rental income and bank deposits. The shortfall and consequent need for a write-down were specifically referenced in the agreement, yet the parties included no provision concerning exactly how the write-down would be implemented for financial and tax reporting purposes. The omission, intentionally or not, opened the door to the accounting dispute and years of additional litigation.