In the famous case of Meinhard v Salmon, Justice Benjamin Cardozo wrote in lofty language that lawyers of maltreated business owners have loved to quote ever since that the duty of loyalty among closely-held business owners is exceedingly high:
“Not honesty alone, but the punctilio of an honor the most sensitive, is . . . the standard of behavior.”
Countless published decisions since cite Meinhard. Steeped in morality-laden language (no “morals of the marketplace” here), it is unsurprising that the tort of breach of fiduciary duty as expressed in Meinhard has become the workhorse of New York business divorce litigation.
Over the years, the common-law cause of action for breach of fiduciary duty has evolved into a remarkably versatile claim, encompassing a vast — almost limitless — range of conduct that can be characterized as misappropriation, self-dealing, waste, or disloyalty. Breach of fiduciary duty in New York also has a number of odd legal quirks, making it a powerful weapon in the petitioner / plaintiff’s arsenal when thoughtfully pled.
As just one example, the claim has not one, not two, but three potential statutes of limitations. If the claim seeks solely money damages, the limitations period is three years. But plead the claim as one seeking equitable relief, and the limitations period jumps from three to six years. Plead the claim as “fraud-based,” and the limitations period extends ever further – six years from the date of the fraud, or two years from when the fraud could have been discovered with reasonable diligence, whichever is longer.
A recent decision from a Rochester-based appeals court, Howard v Pooler, ___ AD3d ___, 2020 NY Slip Op 03347 [4th Dept June 12, 2020], highlights two other exceedingly useful aspects of the tort of breach of fiduciary duty: first, the availability of “disgorgement” of profits from one who breaches a fiduciary duty even in the absence of any actual damages as a result of the breach; and second, the potential for the non-breaching party to recover its attorneys’ fees prosecuting the fiduciary duty claim where the claim is pled derivatively on behalf of the entity.
Howard and Pooler formed Archer Rd. Vista LLC (the “LLC”) to develop a residential subdivision on 300 acres of land in the Town of Chili. They planned to develop the land into approved vacant lots to sell to builders who would then construct homes on the land. The LLC had a written operating agreement, according to which the two members had equal voting rights though they owned disproportionate membership interest (Pooler owned 60%; Howard 40%). The operating agreement designated Pooler “manager,” a position Howard alleged Pooler abused, resulting in a breakdown of the relationship and Howard’s filing in 2013 of a complaint in Supreme Court, Monroe County alleging thirteen causes of action against Pooler, among them breach of the operating agreement (Count I), breach of fiduciary duty (Count VII), and accounting (Count VIII), all pled derivatively on behalf of the LLC.
The Underlying Orders
In 2016, former Commercial Division Justice Matthew A. Rosenbaum issued a decision and order granting Howard partial summary judgment on the issue of liability on his derivative claims for breach of contract, breach of fiduciary duty, and accounting. The court ordered a trial on damages as to those causes of action and on liability for the remaining causes of action. In 2017, the parties tried the case over a week of testimony in a bench trial before Justice Rosenbaum, as a result of which the Court in 2018 issued a decision and order which ultimately led to Pooler’s appeal.
In his post-trial decision, Justice Rosenbaum awarded Howard damages of over $1.2 million based on Pooler’s breaches of the operating agreement and fiduciary duties. In the first of two rulings that are the focus of this article, the court ruled that Pooler breached his fiduciary duties by entering into undocumented self-dealing transactions with a separate entity of which he was principal, Pooler Enterprises. In addition to awarding Howard damages, the Court awarded Howard disgorgement of Pooler’s profits, writing:
Pooler awarded Pooler Enterprises an unmemorialized contract, and the Court has already found Defendant liable in connection therewith. . . Pooler ultimately caused Archer Rd. Vista to pay Pooler Enterprises $692,080 on this unmemorialized contract, with at least $103,812 of that amount attributable to overhead and profit. Accounting for the actual value of the work, the overstatement in the invoices, and the actual amount of work performed, Archer Rd. Vista is entitled to $317,146 in damages, plus pre-judgment interest. Archer Rd. Vista is also entitled to recovery of an additional $103,812, which constitutes the overhead and profit charged by Pooler Enterprises. See Excelsior 57th Corp. v. Lerner, 160 A.D.2d 407, 408-09 (1st Dept. 1990) (“where claims of self-dealing and divided loyalty are presented, a fiduciary may be required to disgorge any ill-gotten gain even where the [Company] has sustained no direct economic loss”). Pooler is not entitled to the overhead and profit charged by Pooler Enterprises.
In the court’s second ruling, it held:
Howard seeks the reimbursement of attorneys’ fees in connection with the derivative claims. The Court agrees and damages in that regard are granted. Likewise, Howard seeks fees as a derivative Plaintiff acting on Archer Rd. Vista’s behalf. The Court agrees, and fees in this regard are also granted. See, e.g., Tzolis v. Wolff, 10 N.Y.3d 100 (2008); Seinfeld v. Robinson, 246 A.D.2d 291, 294 (1st Dept. 1998). . . .
To the extent Howard seeks fees in his individual capacity, no fees are awarded.
In the resulting order, the Court decreed: “Pooler shall be required to pay damages to Howard in connection with attorneys’ fees incurred by Howard as a derivative plaintiff . . .”
Pooler appealed Justice Rosenbaum’s post-trial rulings. You can read the parties’ principal appeal briefs here, here, and here. Pooler tucked away his arguments about the Court’s alleged errors regarding disgorgement and attorneys’ fees as the last two points of his brief. In its Memorandum and Order, the Appellate Division affirmed in part and reversed in part these two holdings.
First, the Court held:
Defendant further contends that the court erred in the amount of damages awarded in connection with the derivative breach of fiduciary duty cause of action, on which liability had previously been imposed, because there was no showing that the LLC was harmed by his misconduct. We reject that contention. Disgorgement of profit is an appropriate remedy for a breach of fiduciary duty even where the corporation has not been damaged directly by the misconduct (see Diamond v Oreamuno, 24 N.Y.2d 494, 498, 301 N.Y.S.2d 78, 248 N.E.2d 910 ; Excelsior 57th Corp. v Lerner, 160 A.D.2d 407, 408-409, 553 N.Y.S.2d 763 [1st Dept. 1990]).
Second, the Court held:
[W]e agree with defendant that the court erred in determining that plaintiff is entitled to attorneys’ fees and disbursements in his status as a derivative plaintiff acting on the LLC’s behalf and in awarding such fees and disbursements, . . . ‘The basis for an award of attorneys’ fees in a shareholders’ derivative suit is to reimburse the plaintiff for expenses incurred on the corporation’s behalf . . . Those costs should be paid by the corporation, which has benefited from the plaintiff’s efforts and which would have borne the costs had it sued in its own right’ (Glenn v Hoteltron Sys., 74 N.Y.2d 386, 393, 547 N.Y.S.2d 816, 547 N.E.2d 71  [emphasis added]). Thus, plaintiff’s success as a derivative plaintiff is not an acceptable basis for an award of attorneys’ fees and disbursements against defendant individually.
Disgorgement of Ill-Gotten Gains
The principle that courts may award disgorgement of compensation or profits for breach of fiduciary duty is ancient. Most often, disgorgement is seen in connection with the “faithless servant doctrine,” under which an agent who is disloyal to his or her principal is subject to equitable forfeiture of all compensation from the date of the agent’s first disloyal act. As the appeals court noted in Howard, the most succinct expression of the doctrine comes from Excelsior, which held that “where claims of self-dealing and divided loyalty are presented, a fiduciary may be required to disgorge any ill-gotten gain even where the plaintiff has sustained no direct economic loss.” In the business divorce arena, where allegations or disloyalty and self-dealing are the norm, the potential for disgorgement can be a mighty weapon indeed.
Attorneys’ Fees Pursuing Derivative Fiduciary Duty Claims
Section 626 (e) of the Business Corporation Law, a statute that has been followed In cases involving LLCs, authorizes courts to award attorneys’ fees to litigants who are “successful, in whole or in part” prosecuting derivative claims. But the statute does not specify who pays the fees. One could make a solid argument that the tortfeasor — the one who caused all the harm — should be responsible for paying the fees. But in Howard, the Court emphasized an important limitation on the ability to recover fees: the entity itself — not the wrongdoer — is responsible for those fees payable out of the recovery.
So when you’re gearing up to start a business divorce lawsuit, think about ways to maximize the potential of your cause of action for breach of fiduciary duty. Breach of fiduciary duty offers a wonderful panoply of remedies: legal remedies, equitable remedies, a right to an accounting, an award of money damages, disgorgement of self-dealt profits, and finally, if pled derivatively, the potential to recover attorneys’ fees.