A Manhattan appellate panel’s unanimous decision last week in Brummer v Red Rabbit, LLC, 2015 NY Slip Op 02912 [1st Dept April 7, 2015], affirmed the dismissal of an LLC member’s claims for fraud and fiduciary breach based on the controller’s alleged concealment of impending equity investments by a pair of venture capital firms while the member was negotiating a partial buy-out of his membership interest.
The court held that the controller’s allegedly false representations regarding the company’s value and non-disclosure of investor interest “were neither relied upon nor material to plaintiff’s decision to sell.”
It’s an interesting contrast, to put it mildly, with the PF2 Securities case that I wrote about last week, in which a trial court refused to dismiss a minority shareholder’s fiduciary breach claim also based on an allegedly under-valued buy-out and the controller’s alleged withholding of financial information. In that case, the court held that the shareholder was “entitled to receive a fair market value for his stock after fair and complete disclosure and valuation.”
The complaint in Brummer (read here) alleged that around 2005 the plaintiff invested $25,000 in consideration of a 7% membership interest in a start-up venture called Red Rabbit that delivers “healthy” meals and snacks to New York metro area schools. After a period of modest growth, in 2010, the controlling member offered to buy back 6% for $28,500 using a percentage-of-revenue formula based on 2010 annual revenue of $475,000. He subsequently raised the offer to $40,000 which the plaintiff accepted, leaving plaintiff with a 1% membership interest.
The following year, according to the complaint, the plaintiff received notice of equity investments totaling $700,000 by two venture capital firms that received an aggregate 23.58% interest with an implied company valuation around $3 million. The plaintiff alleged that the controller’s negotiations with the VCs preceded his $40,000 buy-out; that the controller was duty-bound to disclose to him the impending VC investment; and that he would not have sold his 6% interest for $40,000 had he known of the investment. His complaint alleged causes of action for fraudulent concealment and breach of fiduciary duty.
The defendant moved for summary judgment dismissing the claims. According to his supporting brief (read here), the evidence showed that, beginning in 2008 and repeatedly over the following two years, the plaintiff requested to sell his entire membership interest or convert it to debt; that plaintiff never sought company financial information in connection with the buy-out and never asked if there were potential new investors on the horizon; that the plaintiff was satisfied to get back $15,000 above his original investment of $25,000; and that plaintiff as a member executed the documents admitting the new VC investors and diluting plaintiff’s membership interest. Defendant argued that whether or not new investors were entering the company or the amount they were paying was not material, and therefore could not constitute fraud or trigger a fiduciary duty of disclosure, because the plaintiff had accepted a company valuation “far less than the valuation” put on the company by the defendant.
The plaintiff’s opposing brief (read here) argued that the defendant sought to avoid liability for his concealment and fiduciary breach “by turning the nature of the duty upside down,” i.e., by putting on the plaintiff an “affirmative obligation . . . to guess that [defendant] was hiding these discussions with the new investors.” Plaintiff further contended that the defendant’s duty to disclose arose from the “special facts” doctrine applicable to one party’s “superior knowledge of essential facts” and that the impending VC investments satisfied materiality under a “reasonable investor” standard.
The defendant’s motion for summary dismissal was granted by Manhattan Commercial Division Justice O. Peter Sherwood in a ruling from the bench after oral argument (read here), finding that the plaintiff had access to the company’s financial records (p. 14); that he was aware the company was on the financial upswing (p. 24); that he admitted in his deposition testimony that his “sole concern” was getting back his invested amount (p. 31); and that “the company was under no obligation to advise [plaintiff] of ongoing negotiating with prospective investors” (p. 39).
In its decision last week, the Appellate Division, First Department, readily disposed of the plaintiff’s appeal, writing:
The evidence of plaintiff’s long-held desire to sell back his interest in defendant Red Rabbit, LLC demonstrates that the alleged false representations regarding the company’s value and alleged concealment of impending investments from additional investors were neither relied upon nor material to plaintiff’s decision to sell. Accordingly, dismissal of both the fraud and breach of fiduciary duty claims was warranted (see generally Lama Holding Co. v Smith Barney Inc., 88 NY2d 413, 421 ).
Neither the First Department nor the parties in their lower court briefs cited the Court of Appeals’ 2011 Centro decision, also involving a case of seller’s remorse over a stock buy-out, in which the court opined that “[w]here a principal and fiduciary are sophisticated parties engaged in negotiations to terminate their relationship, however, the principal cannot blindly trust the fiduciary’s assertions.” In Centro, unlike the Brummer case, the seller gave the buyer a broad release as part of the transaction and therefore had to argue — unsuccessfully, as it turned out — that the majority shareholder/purchaser had a non-waivable fiduciary duty of disclosure that trumped the release. Still, it’s interesting that Justice Sherwood made the connection in his ruling from the bench, when he said at page 27 of the transcript:
[Centro] applies here because here you are talking about [plaintiff] selling shares back to the person he is negotiating with who is a fiduciary. And the question is whether you have to tell your, the person you’re negotiating with, all of the thoughts you have in your head. What the Court of Appeals says is, especially among sophisticated parties there is no such obligation.